OPEC Still Fundamentally Misunderstands U.S. Oil Industry
A new report from OPEC estimates that crude oil production from non-OPEC nations will increase by 950,000 barrels per day during 2017. This is a dramatic increase from last month’s estimate of a non-OPEC rise of 580,000 during the year.
This new, much higher estimate has raised concerns within the OPEC cartel that its efforts to balance the global supply/demand equation will require it to either extend its current production limitations into 2018, or to agree to even deeper cuts in its member countries’ own production levels. Based on these concerns, the new report urges all non-OPEC nations to limit their own production:
A large part of the excess supply overhang contained in floating storage has been reduced and the improvement in the world economy should help support oil demand. However, continued rebalancing in the oil market by year-end will require the collective efforts of all oil producers to increase market stability, not only for the benefit of the individual countries, but also for the general prosperity of the world economy.
The report singles out U.S. shale producers as the main culprit for the lingering over-supply situation. This is not surprising, given that overall U.S. oil production has risen by a whopping 800,000 bopd since last October, as U.S. producers have activated more than 250 new drilling rigs and implemented higher drilling budgets for 2017.
This expectation that U.S. producers are somehow going to join together with the national oil companies and controlled markets of OPEC, Russia and other countries to intentionally limit production betrays the same fundamental misunderstanding of the nature of the U.S. oil and gas industry that created the global supply glut and resulting price collapse in the first place.
To review, back in 2014, Saudi Arabia, concerned about the loss of market share it had absorbed as the U.S. shale revolution almost doubled U.S. overall production from 2009 through early 2014, embarked on a strategy in which it would intentionally crash the global crude price by dramatically increasing its own production and exports. The thought at that time was that, by crashing the price of oil, drilling in the U.S. would collapse, and producers who were focused on drilling these capital-intensive horizontal shale wells would by and large go out of business. Even better, because the 2014 break-even price of the average U.S. shale well was in the range of $70/bbl, the U.S. industry would remain depressed so long as the price remained below that level.
This strategy had the shortcoming of only being half-right. Drilling in the U.S. did indeed collapse, as the oil rig count dropped like a stone, from more than 1,600 to fewer than 400 in very short order. While few companies ultimately went out of business, well more than 200 U.S. upstream companies have gone through the bankruptcy process, with the assets of some being absorbed by other producers. So that part was right to a large extent.
But what the Saudi market share strategy failed to understand was the impressive nimbleness and aptitude for rapid innovation possessed by the U.S. oil and gas industry. They did not anticipate that service companies and shale producers would be able to so dramatically lower costs and increase recoveries over the past three years through the development of new technologies, the strategic capture of economies of scale, and refinement of internal processes.
Because of that, they also did not anticipate that the break-even cost associated with drilling shale wells in the U.S. would fall to as low as $40/bbl in the Permian Basin, and into the $50/bbl range in some other major shale basins. Saudi Arabia and the other OPEC countries more recently also failed to understand the urgent need for U.S. producers to drill wells in order to remain going concerns. They apparently had never heard the old oil industry saying that “if you aren’t increasing your production, you’re going out of business.” This saying may be old, but it remains as true in the U.S. today as it was a century ago.
Thus, leading into 2017, the previous two years of little drilling had led to a pent-up sense of urgency within most U.S. upstream companies to significantly increase their drilling budgets for 2017 and the swift activation of more than 250 additional drilling rigs that has led to the rapid rise in overall U.S. production. Not to brag (ok, to brag just a little), I tried to warn everyone at the first of the year that this exact scenario was going to take place here in the U.S. this year. Here’s what I wrote last December 28:
Domestic producers will drill themselves back into a lower price situation- try as they might to maintain a price for oil in the $55/bbl range, OPEC and Russia can’t control the way U.S. producers will react to this higher price paradigm. Nor can anyone else, for that matter. We should expect U.S. producers to activate another ~200 drilling rigs during the first four months of 2017, a trend we’ve already been experiencing since OPEC reached its agreement on November 30, as the U.S. rig count rose by 70+ during December alone. Combine another 200 or so rigs with steadily rising expected ultimate recovery rates from each well, and we should look for overall U.S. oil production to rise by about half a million barrels per day over the first half of the year. The likely result will be higher price volatility and a probable resulting fall-back to prices in the high- or even mid-40s.
Obviously, no one at OPEC was listening. Go figure.
This current expectation by OPEC that U.S. producers will somehow jointly agree to artificially limit their own overall production also betrays an ongoing fundamental lack of understanding about the nature of America’s oil and gas industry.
First, the U.S. upstream industry consists of literally thousands of individual companies, every one of which has its own discreet management team, its own business plan, and its own goals. More to the point, the great majority of these companies are partnerships or corporations, every one of which has its own discreet set of investors it must satisfy in order to remain in business. The thought that these thousands of companies could behave in the same way as OPEC nations, most of whose industries are government-controlled, is not a realistic proposition.
Second, and even more to the point, the corporations among these U.S. companies are legally prohibited by U.S. anti-trust laws to even attempt to engage in cartel-like behavior. It’s not legal.
Third, there is simply no mechanism in U.S. law or regulation at the federal level, outside of the implementation of martial law in a national emergency, that would allow the U.S. government to order the country’s oil and gas producers to artificially limit their drilling and production. Some states – like Texas, North Dakota and Louisiana – do have the regulatory ability to implement production quotas on wells within their borders, but that is a political hot potato that none of the regulatory bodies are going to want to touch.
Bottom line, U.S. industry cooperation in any sort of global production limitation agreement not only won’t happen, it can’t happen.
OPEC and the rest of the global oil industry finds itself in its current position due to a fundamental lack of understanding about the nature of the U.S. industry that existed in 2014. Nothing is going to really change until that lack of understanding is remedied. OPEC’s latest monthly report demonstrates we have yet to arrive at that point.