Since October 2016, U.S. crude oil production has surged by over one million barrels per day, replacing more than two-thirds of what the Organization of Petroleum Exporting Countries (OPEC) was supposed to cut to shore up prices. However, it looks like the growth in U.S. production is quickly running out of steam (Figure 1) and, all else being equal, this should be good news for OPEC and the price of oil. Those hoping to see a continued rise in U.S. production should have two immediate concerns:
The number of operating oil rigs plateaued at just over 750 in July, according to data from oil services provider Baker Hughes. This by itself may point to a decline in U.S. oil production. However, it takes, on average, about four months or so for an oil rig to begin producing significant amounts of oil – although time lags can be vary considerably depending upon the equipment and the field. And, there are about 100 more rigs operating today than there were four months ago. This suggests the possibility of some further upside for oil production over the next few months.
What is more concerning is the collapse in marginal rig productivity. When the oil market began to rise last May, the energy industry deployed its best equipment to its most promising fields. Initially, each additional rig contributed 6,000 barrels of oil per day within four months to U.S. total production in excess of the depletion rate. As time went on, the number of rigs soared and U.S. production continued to rise. But by February of this year, the marginal productivity of each new rig fell by about 75%; each new rig was adding only about 1,400 barrels per day in excess of the depletion rate. This reflects both the short-term nature of many of the shale plays, with fast rises and quick declines in oil production as well as the fact that the energy industry had been deploying less advanced equipment to less promising fields as much of the low hanging fruit had already been picked.
As such, the 100 or so oil rigs that have been added over the past four months might add (optimistically) 150,000 additional barrels per day to U.S. production. This surge in production is still making life difficult for OPEC but U.S. production may soon peak again at around 9.75 million barrels per day, matching but not exceeding its level from the summer of 2015.
For an indication of when U.S. production might begin to decline, look at both the rig count as well as the marginal productivity of additional rigs. Rig counts stopped increasing when oil prices fell back below $50 per barrel. Now that prices have recovered a little, it will be interesting to see if the energy industry responds by deploying more equipment. Even if it does, however, it will not be a guarantee that U.S. production will continue its rise. For that to happen, the rigs have to produce more oil than is being depleted from existing wells – both traditional ones and in fracking.
U.S. production could be on the decline again within a few months, and if that turns out to be the case, it will be bullish for oil, all else being equal. The good news for consumers and others hoping for lower energy prices is that all else is not equal. OPEC is notorious for not complying with production cuts and could eventually throw in the towel on curbing output. Already, cracks are appearing in the organization. On the upside for oil prices are issues of political stability: Venezuela is rapidly descending into chaos and is far from the only oil-exporting nation with the potential for instability.
One other potentially bullish factor: oil inventories, which soared for the past three years, are showing their first year-on-year declines since 2014 (Figure 3). In the short-term inventory reduction, might put downward pressure on oil prices as the market clears. However, smaller inventories should eventually put a foundation in place for the next oil bull market.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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