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Why Oil Production Is Increasing, Despite the Oil Glut

by | published November 12th, 2015

We have just come out of a period in which crude posted a modest recovery. Through close on November 3, West Texas Intermediate (WTI) – the crude benchmark traded in New York – had improved to $47.90 a barrel, up 4.3% for the week. Dated Brent, the equivalent benchmark set in London, was at $50.52 – higher than at any point since October 9.

WTI closed at $42.93 yesterday, down 1.4% in the six intervening sessions. Meanwhile, Brent was at $45.83, down 9.3%. Both are sitting at two-month lows.

The “culprit” was another anticipated rise in production, primarily in the U.S. Despite weekly declines in the number of working rigs in the American market (now at the lowest levels in some six years) and, as I noted in the last Oil & Energy Investor, rising cuts in capital commitments for new projects, the market surplus in oil is once again rising.

Crude oil prices are languishing in the face of what is projected to be another build in U.S. production stockpiles.

Given all that has been said about an oil glut, why is the production continuing?

Field Technology Has Advanced at a Rapid Pace

There are two overriding answers.

First, as the surfeit of shale and tight oil production hit the market a year ago, and continued thereafter, developments in field technology advanced even quicker. When oil prices were north of $80 a barrel, operational costs were of little consequence.

True, well efficiency was not something entirely discounted. But the profit margins were so large that companies could provide nice returns by running more or less traditional operations.

Remember (as I have observed in Oil & Energy Investor on a number of occasions), most companies were cash poor during much of the last decade with a ready and affordable debt market only too eager to make up the working difference.

When prices began the downward spiral, however, and continued descending by some 60%, efficient field operations became essential. The more expensive new projects were mothballed, but new approaches to drilling, pad design, well completion, and workovers were introduced, declining wellhead costs.

Added to the technological improvements one could see on the surface, advancements in enhanced and secondary recovery techniques downhole brought more oil up from each well. The average production, coupled with a greater amount of known reserves becoming accessible, began to rise.

More Efficient Field Operations Boost Surplus

Now, in the case of unconventional (shale/tight), horizontal, deeper, fracked wells the primary production would still come up in the first 18 months or so. Extraction would continue longer than that but at an increasingly reduced rate.

Some of these wells could experience a short-term improvement via water flooding, natural gas injection, chemical treatments, or other secondary/enhanced techniques. Yet as the market price declined, for larger projects these techniques became cost ineffective. Companies would cream the easiest production from first flow.

Nonetheless, the aggregate amount of oil coming up significantly expanded. The primary reason for the current consistent surplus arises from the introduction of more efficient field operations, allowing cash-strapped companies to continue production even as the wellhead price (the producer’s revenue from the first exchange of oil, always lower than the resulting market price) went down.

Debt Leads Producers to Pump More

That set the stage for the second factor. Given that 80% or more of overall project expenses are front loaded (that is, spent before anything comes out of the ground), a company will want to recover investment by a resulting oil flow… even if that flow is feeding into an oversupplied and lower-priced market.

This need to sell what comes up is accentuated by the intensifying fiscal squeeze now under way. Most operators are carrying heavy debt. Previously in a higher-priced market companies would simply roll over that debt into new paper. Unfortunately, energy debt now occupies the most risky range of “junk bonds” (high-yield debt well below investment grade).

Even if new bonds can be obtained, they carry unsustainable interest rates with default risk increasing in a low crude pricing scenario.

The recent rise in companies being unable to operate in this squeeze has resulted in moving as much additional volume to market as possible in a desperate attempt to stay one step ahead of the sheriff.

Making Money Has Nothing to Do With Waiting for High-Priced Oil

The combination of additional volume per well resulting from better applications and the dire straits of more companies trying to stay above water means every time a recovery in price is experienced, the market is likely to see additional oil for sale.

Of course, this is hardly a long-term effect. More bankruptcies, mergers, and acquisitions will ensue. Ultimately, the market will rebalance with fewer players and the price will drift higher.

But there is going to be some pain from the “creative destruction” under way.

Investors need to understand that making money in the current energy sector has nothing to do with waiting for oil to return to $100 a barrel. This is all about identifying those companies that are going to maintain and increase market share.

That will be taking place well before the price of oil begins to accelerate.

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  1. Doug H
    November 12th, 2015 at 13:46 | #1

    Today’s unsustainable low oil price against the back drop of hard investment losses means that production will fall after a predictable 18 month death struggle. As a long time producer/operator, let me emphasis that we are producing oil from investments which have already taken the hit. As expected, oil production won’t drop as due to the change of value economics when costs of implementation are no longer considered in mergers, fire sales and picking up abandoned production for the price of equipping or turning on the electric power. Yet, someone has taken the losses. As we near the 18 month mid stage 2015 crash cycle, year-end losses will soon continue their shock and awe, as in the past. Our banks will suffer, our institutional investors/managers will find themselves as oil tycoons managing fields far from their desks in NYC with the goal of doing all they can to maintain production and keep leases current while the skeleton crews do just enough to maintain a graceful slide in production. The service companies are getting what they deserve as they have found that ripping off the small producers in good times is a right of passage. The big service boys just act like innocent bystanders as they lay off hundreds of thousands of their human fodder field personnel without delay. Having just attended a speech by the SPE President, Nathan Meehan, he pointed out that there is little that has actually changed in our work and recovery. And if you are hoping for the magic pill, there isn’t one. There is NO technology that can facilitate current low prices in the US, nor is there a technology that innovates larger recoveries of any consequence.
    Ultimately, demand will outstrip supply, it always does. There will be little different in this crash. The real hope for long term planning is to have an Energy Policy that tackles our vital National Security interests. It cannot be based on an energy policy that depends upon buying cheap oil from an unfair competitor in the middle east. Our second hope is that we find massive domestic resources in a new US province that will offer billion barrel fields in numbers we haven’t seen in the USA. Possible? Look west. Utah is within a few years of sending shock waves that will be felt throughout the world.

  2. November 12th, 2015 at 21:02 | #2

    No body talks about an energy policy that protects American oil! How about a $10 per barrel tariff on imported oil. giving the us some added revenue and protecting domestic oil.

  3. Ed M
    November 12th, 2015 at 21:52 | #3

    Ok so how can we identify those companies? It’s hard to believe that p/e analysis or similar metrics are going to tell us. It would appear that one needs to know a lot about what techniques they are using , what there cost of production will be going forward etc. do you have an advisory service that does that analysis? One example of how somebody can be fooled is investing in a company who has a big cash hoard but has only hard to get oil. Their future prospects would be bleak.

  4. Tyson Vantrease
    November 15th, 2015 at 13:26 | #4

    I’m going to take advantage of these huge lay offs in Houston if I get laid off I will go straight to University of wherever and get my degree in anything that would further me up the corporate oilfield ladder. I will come out ahead living and going to school on campus. I’d trade in my V8 for a scooter and better my self and my career for future oilfield work.

  5. radha reddy Hindi
    November 17th, 2015 at 06:37 | #5

    sir, firstly the only energy/oil sector that is doing well here is lubricants. I think oil derivatives space like lubricants, grease will do well as every vehicle electric or gas needs lubricants!
    secondly, there is a ugly dichotomy shaping the financial markets since 2012. Asset/commodity prices are falling but yet all consumer foods and services prices are shooting up. i have several examples from across the globe. For example, in our country despite record crop productions year after year the three essential pulses we put on our dining table are now costing more than beef/chicken prices! in one year prices have shot up 150% to 200%. in ten years we have seen about 600% rise in prices of pulses. That is how these hedge funds and their cronies are making money across the globe!

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