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I stumbled across an interesting piece on the US oil market this week from “Hedge Fund Insights”, a contributor to “Seeking Alpha”. The note considered the received wisdom (by me included) that US shale oil production would resume once WTI hit $50 per barrel. This was viewed as being a factor in capping further rises in crude and could even contribute to pushing prices back down towards the lows seen earlier this year.
  
The author began by noting that most big Wall Street firms are bearish on oil. There are a number of reasons for this including observations that inventory levels are high, supply outages (due to factors such as the Canadian wildfires and Nigerian sabotage) are temporary, the US dollar is strong, global economic growth is slowing, drilled-but -uncompleted (DUC) wells could quickly come back on stream and that output from US shale oil will pick up once WTI hits $50.
  
As I understand it, the last two factors are related and it is these that the report addresses. The author explains that there is a major difference between shale and conventional production. With shale production, output from a well falls off dramatically over the first 18 months of the well’s life. In other words the rate of decline accelerates. In fact, looking at data from the Bakken fields the decline rate can be as high as 80% in the first year. As the author goes on to explain, the problem comes when the oil company wants to boost production. The cost of replacing the lost production due to natural decline goes up as does the cost of adding to overall production. So do servicing costs. Over the last six years, rather than using cash flow to fund this extra production, the drillers turned to debt financing instead. This made sense given the cheap borrowing costs made available by the Federal Reserve’s easy monetary policy. But with the collapse in the oil price that is no longer an option. Now, with banks unwilling to lend further, future growth for drillers will have to be financed by cash flow. The author calculates that $50 per barrel just isn’t enough for shale producers to thrive on cash flow alone. While noting that some drillers will be able to up production at $50, the majority need a price closed to $70 to be long-term viable. If the author is correct then with WTI at current levels we can expect the recent uptick in US production to tail off over the coming months.
  
As an aside, the chart below shows US crude inventories as calculated by the Energy Information Administration. What this shows quite clearly is that despite recent drawdowns, crude stockpiles are at extraordinarily high levels and are up sharply from this time last year. I can’t help thinking that we’re going to need a dramatic cut in output, together with a booming global economy to take US inventories back down to the twenty year average. But so far this overhang has failed to dampen bullish enthusiasm.
  
 PM Bulletin  
  *The SPR is the “Strategic Petroleum Reserve” which is in essence a back-up should there be a severe US shortage.
  
David: Looking at data from the Bakken fields the decline rate can be as high as 80% in the first year.
  
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Posted by David Morrison

Category: PM Bulletin


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