Remember that the rigs that have been closing down have not been affecting the capacity to produce crude yet and the reason is that most of them are [...] the inefficient rigs.
-Alan Greenspan, former chairman of the United States Federal Reserve
This article is aimed at questioning a little-questioned assumption which appears to be extremely common among oil analysts at the moment. Wherever you go to read up about the unprofitability of the majority of shale projects at current oil prices, or what impact the collapse in rig counts will have on US crude oil output, analysts and "oil people" are constantly reminding us that shale drilling productivity has been increasing rapidly every year and that it will likely continue to do so in the future, which they assure us, will overshadow steep rig count declines. I intend to show that this is a delusion, and that productivity increases are likely a result of the very so-called inefficient rigs which analysts claim will have no impact on oil output.
After a continuous decline in the US since the early 1980's, crude oil output took off like a rocket ship in recent years - nearly doubling in the last 5 years thanks to the shale oil revolution. In part, underlying the shale oil revolution has been a phenomenal increase in the productivity of the drilling technique known as hydraulic fracturing. This technique allows drillers to tap into and exploit source rock oil and improvements in horizontal drilling dramatically increased the productivity of each well drilled: instead of drilling one well vertically, a horizontally drilled well is able to cover a much greater area underground and can therefore target more oil pools per well drilled. These innovative techniques and resulting productivity increases have unleashed enormous oil reserves which were previously completely uneconomic in the US.
Rusty Braziel, the president and principal energy markets consultant for RBN Energy, has broken down the impressive figures for us:
In 2011: the average shale well took 22.3 days to drill.
In 2014: the average shale well took 8.9 days to drill.
In 2011: the average rig drilled 16 wells per year.
In 2014: the average rig drilled 41 wells per year.
In 2011: initial production rates averaged 533 barrels of oil per day.
In 2014: initial production rates averaged 767 barrels of oil per day.
This means that the oil generated per rig per year has increased by an astonishing 239% since 2011 (from about 9 million barrels to about 31 million barrels).
Analysts (who failed to foresee the collapse in oil prices in the first place) are now telling us that a rapid and more than 50% collapse in rig counts is likely to have a negligible impact on crude output in the US because the rigs which are being laid off are "unproductive rigs" which are either vertical rigs or are rigs largely dedicated to experimenting with new drilling techniques, targeting/delineating new shale formations, and other such "tinkering" purposes which appears to be unproductive when compared with concentrating rigs on the highest return so-called "sweet spots".
The rapid expansion in US oil output, and a large part of the reason that such a substantial number of drilling rigs were put to work merely experimenting and tinkering, has also been funded by record low interest rates as well as record borrowing on behalf of energy companies - to the tune of $550 billion in fresh loans since 2010. Worryingly, much of this borrowing has been by companies of questionable financial soundness: in 2005 the proportion of the total junk bond market composed of energy companies was about 4.6% and it now stands at over 15%. In 2003, the outstanding bond issues for the entire US energy sector totaled less than $200 billion, and now about $200 billion out of the total $800 billion (or 25%) of US energy bonds outstanding are "junk" or risky high yield bonds.
Productivity increases and cheap credit fuelled a massive expansion in the shale oil patch: at the peak of rig use in the US, prior to the onset of the Great Recession, no more than about 400 drilling rigs were active in the oil patch (and this itself was an elevated figure in comparison with prior years where the rig count averaged no more than about 200). After the shale revolution, the rig count rapidly shot up to a peak in 2014 of about 1600 active rigs. In response to declining oil prices, the current number of rigs drilling for oil in the US now stands at a paltry 734, as reported by Baker Hughes on April 17, 2015.
As oil prices collapsed, the yields on energy-related junk bonds shot up from 5.7% to 9.5%, and are currently hovering at around 8.8%. At-risk energy companies will now be burning the proverbial candle at both ends as their refinancing costs skyrocket at the same time that their profit potential collapses. As the rig count indicates, the experiments and tinkering have halted completely. Energy companies can no longer afford these once-so-popular uses of capital. In the words of Rusty Braziel "[because of the oil price collapse...] I only drill those projects that are likely to get the best results."
It is a fallacy to refer to rigs dedicated to experimentation and tinkering - and indeed if such a large percentage of the rigs were engaged in these activities that ought to tell us something about their importance - as unproductive on the basis that, in the near-term, they do not generate rates of return or output numbers resembling the high-impact formations.
In his book, "The Black Swan: The Impact of the Highly Improbable", Nassim Taleb argues very convincingly that technological advance comes about largely through bottom-up tinkering and experimentation. Inventors often accidentally stumble upon important new techniques while attempting to solve other, unrelated problems.
Well, the extremely cheap credit and high returns (promised by high oil prices) in the shale oil patch, which fuelled an enormous number of rigs to be dedicated to tinkering and experimentation/exploration is just the sort of laboratory of innovation which, according to the logic laid out by Taleb, is likely to drive massive increases in productivity as new processes and techniques are rapidly discovered through the tinkering process which then filter through the industry and boost overall productivity rates. Therefore, while these rigs may be said to be unproductive in terms of an internal rate of return projection, collectively the techniques and technologies discovered through experimenting with these "unproductive rigs" are likely playing an enormous role in the overall rapid productivity increases in the shale industry as a whole.
There were some projects being drilled that were called 'science projects' [...] these science projects have bit the dust.
-Rusty Braziel, president and principal energy markets consultant for RBN Energy
This is why it is a fallacy for analysts to assume that a rapid collapse in oil rig counts in the US, combined with a collapse in experimenting/tinkering will not significantly impact US crude oil output capacity in the future because of the widely-cited productivity increases - because the productivity increases themselves are likely being substantially driven by the very experimentation which was deemed "inefficient" and unproductive by folks such as Alan Greenspan.
The prediction from this hypothesis is that, while oil output in the near-term may not fall off a cliff in the US, the assumption that productivity increases will continue at-or-near present rates and therefore overshadow rig count declines is likely to be a delusion on par with believing that housing prices will continue to increase at rates far exceeding their historical norms far-off into the future merely because they had done so in the recent past. Instead, we may find that future productivity increases will be overshadowed by and because of rig count declines.
