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U.S. shale producers continue to surprise industry experts and competitors, as production declines are far lower than anticipated, even after rig counts have plummeted by about 75 percent, capital expenditures were cut, and over 100,000 workers have been laid off.
After all of that, the Energy Information Administration (EIA) estimates shale production in the U.S. will fall by only about 7 percent to approximately 8.7 million barrels per day in 2016. With a lot of new shale supply expected to be brought into production in 2016, even that may be too low of an estimate. The next couple of quarters will reveal whether or not companies follow through on bringing promised new supply to the market.
Even under these low-price oil conditions, they could generate a profit with the drilled but uncompleted wells, where the initial expenses are already priced in. It would cost some to start drilling, but once they're operational, the costs are surprisingly low. That at a time when shale producers in the U.S. have significantly increased the productivity of their wells.
This is why even when rig counts continue to drop and bankruptcies multiply, shale output remains relatively strong.
Why oil rig counts no longer reflect production levels as in the past
Before the emergence of the U.S. shale industry, the number of oil rigs in operation were a fairly accurate measure of production levels and where they would be going forward. That is no longer the case because improvements in efficiencies and productivity have resulted in wells producing a lot more than just a couple of years ago.
The EIA says a well drilled in the latter part of 2015 produces about double of what a well drilled just two years earlier produces. That's an enormous improvement that has been a major part of the reason shale oil has outperformed expectations.
It has yet to be confirmed, but this could also bring about a much longer time frame of high productivity, which in the past has dropped significantly in the first year. If that is improving, which I believe it is, we may see U.S. supply doing better than even the most optimistic outlooks.
Another reason rig counts aren't as important is the wells starting to dry up could make it not worth keeping rigs in operation, which, while lowering the count, would have little if any impact on supply. Rigs also serve more than one well, which, if they're solid producers, will easily offset many of the underperforming rigs.
Rigs being removed from low-producing wells and increased productivity from new wells has brought about a need to change the way rigs are determined to have an impact on the industry. Why the low-producing wells are important to note now is, in the recent past, shale wells did in fact lose a lot of production after the first year. This means a quicker shrinkage of rigs, but not necessarily a lot of output loss as new wells launched production.
One of the things I'm looking for is whether or not the increased productivity relates to extended life of the shale wells, or it means more oil is produced on a daily basis. If it's both, it's going to force analysts and investors to further rethink how to view rig counts.
Costs for existing U.S. shale wells
A little known fact is U.S. shale wells, once they become operational, can produce oil at an average of around $20 per barrel; some do a little better and some a little worse, but that's the general average. That's why many shale producers continue to pump at these low price levels. They are still making a profit.
Some may think that doesn't make sense because of how poorly upstream is doing for companies, but that has to be analyzed on a company-by-company basis, because shale, in many instances, isn't the only, or possibly not even the primary type of deposit being worked.
There are also the costs of bringing a DUC well into production, even though major costs to drill and cap them have already been incurred. Output needs to ramp up even though the bulk of the work has been completed.
So while about $20 per barrel is an accurate average cost measure for existing shale wells, it needs to be understood against the backdrop of shale wells being brought into production and wells outside of shale itself.
The point is active shale wells, because of the low-cost basis, can continue to generate profits unless the price of oil drops to about $20 per barrel. That means only a drop in well production will cause a decrease in supply, not a decline in rigs. Even bankruptcies don't have an impact because it's in the best interests of shareholders to allow the company to keep production going in order to get at least a portion of their capital back.
For that reason, even with a growing number of bankruptcies and declining rigs, there hasn't been a meaningful decline in output.
Where bankruptcies could have a negative impact
In most cases, bankruptcies in the oil sector aren't having much of an impact in the present because of the aforementioned allowance of producers keeping the oil flowing. But further out it could become a problem once the wells start drying up. We don't know how that will play out in the case of shale production because of the rapid improvement in production and lack of data showing how that will extend the life of the well.
We already know that overall the output has doubled in two short years, but we don't know if that is continuing to be the case, and if the production gains are being extended over a period time, or if it's being improved on a daily basis. Why that matters is, it will determine how to analyze improved productivity within a specific period of time.
It also matters because cash flow will determine whether or not there will be any capital available to develop new wells for those companies under duress. If existing wells have both extended life and daily production level, it could improve the current performance of the company while giving it a chance to invest in new production.
On the other hand, if we're at or near the upside potential for shale wells, then it's only a matter of time before drilling and production declines, with no capital left for investing in the future. The consequence is once the existing low-cost wells slow down, there isn't a lot more weak producers can do. Inevitably that will result in a lack of access to credit for new projects.
The negative impact of bankruptcies isn't going to be in the near term, but will drag on supply once output declines to lower levels. Even in the best-case scenario, there will need to be new wells developed and brought into production in order for output levels to hold their ground or gradually decrease.
Where this gets complicated is in how many of the wells a company may have are DUC wells, and what it will cost for them to bring them into production. If there is enough existing capital or credit available, it could extend the life of a company, and if they hedged at a decent price during the oil rally, it could give it further life expectancy, even during a bankruptcy process.
In my view, one of the best things to happen to the shale industry is the low price of oil. It forced the industry to increase efficiencies, lower costs and improve the productivity of wells, even while rig counts plummeted and thousands of workers were laid off.
This has not only disrupted the market because of a new oil supply and a strategy of drilling but not completing wells, but it has changed the way the market should view rig counts and who has the influence on the price of oil at different points. For example, OPEC and Russia, if they continue to produce oil at high levels, have more of an effect on the lower side of oil prices, while shale producers, because they can bring wells into production at the most opportune times, have more control of the mid and upper range of oil prices.
The days of OPEC changing production levels and moving the price of oil to desired levels are over. Saudi Arabia has been trying to tell the market that for a couple of years, but many still don't get the fact that a production freeze or cut would do nothing to alleviate the low-price issue, as more production would be brought to market, with the losers being those giving up market share in order to provide support for oil.
That's why the Saudis are correct in stating they are going to allow the market to do the rebalancing. It's not that Saudi Arabia has suddenly given up its control, it's that it no longer has the control it had in the past in regard to the price of oil.
For the same reasons, an increase in bankruptcies isn't going to have the negative impact the market will probably believe is coming - at least in the short term. If access to capital shrinks and new projects are put on hold, eventually that will bring about lower supply from U.S. shale producers, but that is further out than originally thought.
Over the next year or so, it doesn't really matter what ancillary events happen, including bankruptcies or declining rig counts. Improved productivity by U.S. shale producers and thousands of DUC wells sitting on the sidelines mean the decline in production is going to be much more gradual than believed.
Until inventory levels are drawn down and demand lines up with supply, there is nothing that will change the oil outlook anytime soon.
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.