Andreoli on Oil and Fuel: The “perfect storm” for oil producers brings relief to consumers

Since 2011, domestic oil production has increased by 4.5 million barrels per day (bpd), and over the last 12 months alone production has increased by 1.4 million bpd. Meanwhile, Russian production hit a post-Soviet era high in November, and oil exports from Iraq are growing at a record pace.

On the demand side of the equation, the outlook is similarly bearish for oil prices. Domestic oil consumption grew by only 80 thousand bpd between November 2013 and November 2014 despite strong economic growth. The EU economy continues to stagnate while becoming ever more fuel efficient, and the growth rate of China’s GDP has fallen to a 24-year low causing Asian oil demand to slow.

These trends will continue to exert strong downward pressure on oil prices, which is good for consumers of petroleum products in the short-term, but this “perfect storm” will continue to pound domestic shale oil producers, and herein lies the longer-term problem.

The economic breakeven price for the average shale oil well is $65, and even the most profitable wells require oil prices over $50. With oil prices under this level, there is no incentive to continue to drill new shale oil wells, and this is why we’re witnessing a wave of drilling rigs being idled and drilling contracts being cancelled.

The impact of a dramatic slowdown in drilling will not be felt immediately, but domestic oil production growth rates should slow significantly through the year because the average rate of decline of oil production from shale oil wells is around 70 percent over the first twelve months. This means that the production rate in December of a well drilled in January will be just 30 percent of the initial flow rate.

This rapid rate of declining oil production explains why maintaining flat production rates across a shale oil play like the Williston Basin requires high drilling rates, and according to EIA projections, domestic production is expected to flatten by June after adding another 300,000 bpd to domestic output in the first half of the year.

While oil production from the U.S., Russia, and Iraq has increased over the last year, aggregate production from all countries other than the U.S. has been declining, and is projected to continue to decline through the year.

In total, the EIA predicts that global liquid fuels production will hit an apex in the late summer and decline by nearly 100,000 bpd through the end of the year. Meanwhile, global consumption is expected to remain flat. This all suggests that even though markets will begin tightening, they will most likely remain loose through the end of the year. Consequently, investment and drilling will continue to be hampered.

Based on these assumptions, the outlook for oil and fuel prices is optimistic from a consumer perspective, at least through the third quarter, but probably through the end of the year. From a supplier perspective, shale oil producers are victims of their own success, and it’s only a matter of time before a decline in drilling rates push prices back up. Enjoy the low prices while they last, but recognize that lower prices are self-correcting.