Something of a paradox is developing in the US onshore oil and gas sector. Even as the number of rigs drilling for shale oil and gas declines the actual volumes of oil being produced continues to increase.

While the rate at which the rigs are being taken out of service has been slowing — only 33 rigs stopped drilling last week — the overall number of rigs drilling for shale oil is at its lowest level for nearly four years and has fallen about 40 per cent in four months.

Despite the big drop-off in drilling activity, however, US onshore oil production continues to rise to record levels, as do US oil inventories. The US Energy Information Administration, which puts the daily production at more than 9.2 million barrels, sees it rising even further this year.

That might suggest that the decision by the Saudi-led OPEC to maintain production, which helped puncture the oil price and which contributed to the accelerated decline in the price — it has roughly halved since the middle of last year — hasn’t played out as planned.

The Saudi stance has been interpreted as an attempt to drive out the higher-cost US shale oil volumes that have been a major factor in the imbalance between supply and demand that has developed in the market for oil. The decline in the number of operating rigs says that it is having an impact, but the rising production volumes and inventories appear to contradict that conclusion.

Part of the explanation probably lies in the rate at which the productivity of the US shale oil and gas sector has been rising.

It was notable that when BHP Billiton said in January that it would cut the number of rigs operating on its US shale acreage from 26 to 16 by mid-year it maintained its previous production forecasts.

That’s because it had already focused on its most productive oil reserves and because the productivity of its drilling has improved so dramatically — it is getting more oil, in less time and at lower cost, from fewer rigs. It’s a story that is emerging across the entire sector.

Most of the bigger producers have announced similar cuts of around 40 per cent to their capital expenditures this year as they take rigs out of service but, like the EIA, are still anticipating increases in volume relative to 2014.

It might also be the case that, while the number of rigs drilling for onshore oil is falling, the remaining rigs are now focused on the most productive fields — there’s an element of “high-grading” occurring that is maintaining production volumes.

Shale wells, however, have relatively short lives — most of the production from an individual well occurs within its first 12 months, with production rapidly declining thereafter. The relatively abrupt and quite substantial reduction in the amount of new wells being drilled will eventually be reflected in a decline in production.

When it comes — and the BHP game-plan, where 40 per cent of its fleet of rigs will have been taken out by the end of its financial year in June provides a broad indication of the timeline — the impact on production in the second half of the calendar year could be sharp and substantial.

The problem for the Saudis and OPEC is that any material fall in US oil production is likely to be reflected in a spike in oil prices. At present Brent crude is trading at around $US60 a barrel (just under half its peak in the middle of last year) and the West Texas Intermediate price around $US50 a barrel.

Another possible strand for the apparent slowdown in the rate at which drilling activity is reducing might be that companies are still drilling wells with no present intention of producing oil from them. That’s to enable them to leap back into production immediately if the price recovers. It takes very little time and relatively little cost to bring a well into production.

Given the rate of increase in drilling productivity that has already been achieved and the confidence of producers, like BHP, that they can lower costs, reduce timeframes and improve production rates further, the price at which latent production could be brought on stream is now significantly lower than it would have been a year ago.

That’s why, in the absence of the traditional response of OPEC to low oil prices — cutting back its own production and most notably Saudi production — there may well be a ceiling on the price for quite some time. Even if OPEC were to change its stance and reduce its own output, the US shale producers would probably immediately replace that withdrawn volume.

There is, however, a massive cut-back in new investment occurring among the major conventional oil producers, which will take some time to show up but will ultimately have a meaningful impact on supply in the longer term.

That should, in the medium to longer term, leave room for both OPEC and the US shale oil sector to resume production as normal and could well lead to a shortfall of supply relative to demand.

The dynamics of what’s occurring within an oil industry whose structure has been permanently changed by the quite recent and very rapid emergence of US shale oil as a major new source of supply are complex and volatile … and fascinating.

Extracted in full from Business Spectator.

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