Now that oil prices are back up to $50 per barrel, will oil companies redeploy rigs to begin drilling again?
Oil prices have rallied roughly 85 percent since February on the back of falling U.S. production, supply outages in Canada and Nigeria, and rising global demand. Although prices have bounced around violently over the past two years, WTI and Brent have traded in a relatively stable range of $47 to $50 per barrel for the past month, a period of calm that has rarely been seen since the downturn began in mid-2014. In fact, the CBOE Crude Oil Volatility Index, which tracks oil price volatility, is at its lowest level in a year. It is almost as if the markets took a breather in May before deciding on what to do next.
The price gains have come without any assistance from OPEC. The top members of the oil cartel are producing at higher levels than in the past, and there is very little prospect of a production freeze or cut coming this year. So if oil prices are to rally further, they will have to do so because of adjustments to the supply/demand balance in the market.
The short-cycle nature of U.S. shale drilling has raised questions about whether or not the U.S. was replacing Saudi Arabia as the new swing producer. The big difference being, however, that the hundreds of individual shale drillers cannot and do not coordinate – they will spring into action on their own when they see fit. So, is $50 oil enough to bring them back?
There are a few early signs that drilling is starting to begin again. The oil rig count jumped by nine last week to 325 active oil rigs, the sharpest increase since December 2015.
The Wall Street Journal reported that there are a few spots where companies are stepping up drilling activity – the Permian Basin in West Texas, and the Stack play in Oklahoma. The WSJ says that wells in these two plays can earn companies a 10 to 30 percent return with oil prices at $45 per barrel. Continental Resources, an Oklahoma City-based shale driller, says that it can earn a 75 percent return from its best wells in the Stack play, even when oil prices are at just $45. Some of these wells are more profitable because they are located in mature oil regions that have all the needed pipeline infrastructure and processing facilities nearby. There are several examples of companies shifting resources to these areas, reducing operations in places like the Bakken and adding resources to Oklahoma and West Texas.
A handful of companies telegraphed their intentions months ago before oil bounced up to $50 per barrel. Pioneer Natural Resources said in April that it would add five to ten rigs if oil prices returned to $50 and stayed there. “It’s not so much getting to $50 at a particular point in time. It’s having a view that oil at $50 will stay at $50. The industry supply/demand fundamentals have to improve. We have to have a view that it’s a positive price environment,” Frank Hopkins, senior vice president of investment relations at Pioneer Natural Resources, said in April. The WSJ says that Chevron has identified 4,000 wells that it believes will can provide a 10 percent return in the Permian basin with oil at $50 per barrel.
Still, this new drilling activity will only nibble around the edges of U.S. oil production. The U.S. is losing tens of thousands of barrels per day each week – last week the EIA reported a loss of 32,000 barrels per day, for example. Total production is down nearly 1 million barrels per day since hitting a peak in April 2015 and further deterioration is expected. New drilling in Oklahoma and the Permian, for now, may only slow the rate of decline. The industry will need to add many more rigs back to the shale patch before overall production can be reversed.
Of course, a stronger response from the oil industry – several weeks of very substantial increases in the rig count, for instance – would only raise the possibility that oil prices fall back again, putting a dent in the returns of some of those attractive drilling areas and potentially zeroing out any return from more marginal wells.
Oil prices won’t only move based on what happens in the United States. The return of Canadian output will weigh on oil prices, but the outages in Nigeria are ongoing. Iran continues to ramp up production, but those gains could be offset by losses elsewhere. There are so many variables that price forecasts for the rest of this year differ depend on who you are talking to. A WSJ survey of 13 investment banks revealed oil price forecasts for the fourth quarter of 2016 that range between $30 and $60 per barrel.
But, there are two reasons that what happens in the U.S. could matter the most. First, shale drilling stops and starts quicker than conventional drilling, meaning that an uptick in activity could happen in the U.S. before it does elsewhere. Also, the U.S. tends to have the most transparent industry data, which offer some clues about the state of the oil industry, allowing the U.S. to have an outsized impact on short-term price fluctuations. On June 6, Morgan Stanley released a report saying that “all eyes” are on the U.S. to see if drilling will return now that oil prices are back at $50.
Courtesy: Nick Cunningham
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