The Simple Reason American Oil Production Growth Will Slow Significantly

Includes: BP, XOM
by: Devon Shire

It has been an amazing few years for North American oil production. Some of us actually saw this unconventional oil boom coming.

Yes, I include myself in the "saw it coming" camp because I started loading up on Canadian unconventional oil producers a few years ago. Don't worry though, I'm not bragging, my portfolio hasn't done much positive for me because the Canadian Resource sector has been demolished over the past nine months.

The mainstream media has now gotten a hold of the American oil boom story and has come up with such grandiose ideas such as the United States becoming an oil exporter and invented the catchy name "Saudi America".

I'm here to throw a bit of a wet blanket on this.

Here is what American oil production has done over the past few years:

It started turning up in 2009 and has accelerated through this year. The reason behind this is simple, and it isn't going to last forever. This giant surge in production growth is due to a massive shift in drilling rigs away from natural gas and towards oil. Look below at how the oil directed rig count has moved over the past few years:

Starting in 2009 the number of rigs drilling for oil increased every month through July of this year. That rig count surge is what has caused the huge surge on American oil production that we have seen in 2012. That huge surge in oil-directed rig count from 200 in 2009 to 1,400 in 2012 is not repeatable. There are only so many rigs to go around.

If you look at the chart you can see that the oil directed rig count has flattened in 2012. That is going to start showing up in the oil production figures some time later in 2013.

I'm not a skeptic of this unconventional oil revolution. In fact, I'm a big believer. I've got my money where my mouth is and have a huge portion of my portfolio directed at oil resource play producers. But the fact is that these unconventional oil wells have production decline curves where production comes on strong initially and has a huge decrease in the first year. Below is what production from a typical unconventional oil well looks like:

The surge in production we have experienced relates more to the increase in oil-directed drilling rigs than anything else. As the rig count flattens (as it has to) the rate of growth in oil production is going to decrease rapidly. Production will keep growing, but at a much lower rate.

Let me provide a very simple example where we have only one drilling rig drilling wells in an unconventional oil resource play. We will assume that the rig drills only one well per year.

Year One - We go from production of zero to an average of 100 barrels per day (the first year average production from an unconventional well. Production growth in year one is 100 barrels per day

Year Two - We have production from the second well drilled (100 barrels per day) plus production from the well which was drilled in year one (which averages 50 barrels per day in year two) for a total of 150 barrels per day of production in year two. Production growth in year two is 50 barrels a day (150 barrels per day in year two vs 100 barrels per day in year three).

Year Three - In year three we have another new well (100 barrels per day), plus the second year for the second well (50 barrels per day) and the third year for the first well (which is down to 35 barrels per day). Production growth in year three is 35 barrels per day (185 barrels per day in year three vs 150 barrels per day in year two).

Production keeps growing every year as we add wells, but the rate of production drops pretty dramatically. If the rig count does not increase, the amount that production increases each year will drop rather dramatically pretty quickly.

And we are already seeing (as depicted in the chart above) that the oil rig count has flattened.

What that means to me as an investor is that I should keep buying unconventional (and conventional) oil producers, because the price of oil is not going to be in danger of plummeting because of a continued surge in American oil production.

One beaten down company that might be worth the plunge is stinky old BP PLC (NYSE:BP) which still needs a 50% increase in its share price to reach its pre-Macondo levels.

BP pays a nice dividend as it yields over 5% and the outside chance of a value realizing catalyst should one of the Super-Majors like Exxon (NYSE:XOM) decide to finally put shareholders out of their misery.

Disclosure: I 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.