Many analysts and investors continue to get it wrong in regard to the impact of lower oil rig counts on the industry, as past experience suggests the supply coming to the market should drop as the rig count shrinks, which would also slow down inventory build and reduce it. That's not happening, and it should generate the question of why it isn't.
The stakes are high because the most popular scenario for the price of oil in 2016 is predicated upon U.S. shale oil production dropping significantly, with the outlook being for as much as 600,000 barrels per day being cut from supply. With the demand for oil projected to climb by about 1.2 million barrels per day, the idea is by the latter part of 2016 it should rebalance the market.
Based only on the increase in supply from OPEC going forward and the current oversupply, I don't see that happening, and if my thesis is correct with U.S. shale oil, it's possible supply could get a lot worse before the end of the year, because U.S. shale oil could be much stronger with the existing wells in production than is understood. It also doesn't take into account the numerous drilled but uncompleted wells that companies have said in the recent past they plan on bringing into production in the first half of 2016. With the price of oil where it's at now, I doubt prior assertions can be taken as seriously as they were at the time, but it's a possibility some may be brought into production if managements believe the price of oil will climb in the second half.
That said, this article is going to focus on why rig counts aren't as significant as they have been in the past, and what is being overlooked by investors and why. It's important to understand because it could be a major reason the price of oil may surprise many on the downside for much longer than is being considered at this time.
A major reason the oil price continues to make some "industry experts" look foolish is they don't understand the overall nature of the U.S. shale industry and what has changed at the production level. Among those are the ability to localize production in a way that targets areas where there is more oil. For the relatively same cost companies can extract more oil than other areas of the deposit.
Also, a higher hit ratio means a company has a much stronger probability of getter more oil, because the ratio have vastly improved since the turn of the century.
Around 2000 the hit ratio from oil drillers was at about 50 percent; that was the average performance at the time. Today it has vastly improved to a hit ratio of 95 percent.
Combined with improved efficiencies and drilling methods, it has resulted in production far exceeding expectations, which has baffled the industry for some time. It's why supply remains robust and inventory in the U.S. grow, even as the rig count has plummeted over the last year.
It's also why the industry may be surprised once again this year in the probable duration of the low-price oil environment.
Taking hit ratio into account
If investors don't start including the hit ratio as a key part of their analysis of oil companies in their upstream business, they could easily miss a key element affecting the price movement of oil over time.
After all, if some in the market believe the supply of oil in the U.S. will drop by 600,000 barrels per day and it doesn't come close to those numbers, their outlook for the price of oil by the end of the year will be far too optimistic.
Oil demand growth has already been downwardly revised because major consumers like the U.S., China and Europe are now slowing down consumption as their economies weaken - that's especially true in transportation.
Add to that the high hit ratio, and it appears the rebalancing many are looking for isn't going to happen in 2016, and probably not in 2017 as well.
Also lingering in the background is the approximate 4,000 DUC wells that can be brought into production in a short period of time if the price of oil does move up to profitable levels.
The hit ratio has become a strength of the U.S. shale industry from the supply side, and it's a reason the market continues to overestimate the impact declining oil rigs have on the market.
Well decline may be more of an offsetting factor
What's far more important than oil rig counts, as far as it relates to offsetting oversupply, is the rate of decline for existing wells. The bulk of these wells recover close to 50 percent of production in three years or under. As they surpass that age, decline increases significantly on an annual basis.
This is where investors should look when considering the companies they've taken a position in or are considering taking a position in.
Even so, when you think it through, if a company has a number of wells over three years old, it could be considered a positive not to sell into the low-price oil market. The positive of it on the defensive side would be if there were enough of these wells, it could bring the number of barrels per day produced down, which has the potential to support the price of oil. I don't believe that could happen on its own, but if other factors were combined with it, it is possible further out.
On the negative side, as far as it relates to price support, if some of these declining wells are among the rigs being closed down, they will have little offsetting impact on the price of oil in the near term; they are already underperformers.
My thought is these wells are already producing and it would be counterproductive to incur the costs of shutting them down if they have a decent amount of oil left in them. Those further in decline may be more conducive to shuttering.
I look at that as more of a long-term catalyst than something that will support oil in the short term. I brought it up because I see some reports suggesting this could have an impact on oil this year.
For the overall market it's a non-factor for now, but for an individual company it has more relevance if there are numerous wells in decline.
Another element of the disruption of the market because of the growing and resilient U.S. shale industry, is the increasing irrelevance of the number of rigs being closed down. The soaring hit ratio and the improvement in being able to target larger oil deposits has made it much less important than in the past. This is why there is little change in U.S. oil supply and oil inventories continue to increase while the rig count drops.
That isn't to say the drop in oil rigs doesn't have an impact on the industry, it means that impact isn't happening on the upstream side of the business.
Where it does have an impact is on companies like Superior Energy Services (NYSE:SPN), Baker Hughes (NYSE:BHI), Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL), and Weatherford International plc (NYSE:WFT), which provide equipment and services to the sector. Less rigs means less demand.
With hit ratios at historical highs and companies able to target the best deposits, the market could be in for a huge surprise if supply from the U.S. shale industry once again proves it can at least remain close to level, or possibly even grow under these market conditions. I don't think supply levels are going to drop by the upper range of 600,000 barrels per day some think it will.
If that's how it plays out, the duration of the low-price oil environment could be much longer than many are projecting.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.