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Philip Verleger

Philip Verleger

Dr. Philip K. Verleger, Jr., has studied and written about energy markets since 1971. His earliest research, published in 1973, addressed the determinants of gasoline…

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U.S. Oil Production Is Headed For A Quick Decline

The most recent forecasts published by the US Energy Information Administration show US oil production increasing steadily. The February Short-Term Energy Outlook sees the output from US wells rising from 11.9 million barrels per day at the end of 2018 to 13.5 million barrels per day by the end of 2020. Most other forecasters agree.

Thus, it may come as a surprise to learn that production at the end of 2020 may have actually decreased from December’s 11.9 million barrels per day level to between 11.3 and 11.5 million barrels per day. This lower figure represents the production level that should be expected given the financial activity of the independent firms behind the shale output surge.

The coming decline will occur mostly in the areas that have produced the most growth over the last five years: the Bakken, Eagle Ford, Haynesville, Julesburg, and Permian basins. The production drop will occur because the firms operating there have been forced by monetary constraints to cut back on drilling. The recent reduction in debt and equity issuance by these firms assure the output decline.

Drawing an analogy between farming and drilling by the frackers will help explain the coming decrease. Every year farmers borrow heavily to purchase seed, fuel, and fertilizer for the summer growing season. They hope to pay their loans off when they sell their harvest in the fall. To make sure they can perform on their loans, they will sell some portion of or all their production forward. They will also purchase insurance to protect against crop failure.

Data on bank lending and statistics issued by futures authorities provide some advance indication of the planning decisions of farmers. The amount of bank loans issued to them gives an indication of crop size. Increases in open interest for futures such as corn during the spring also provide a signal as to future production.

Many frackers behave like farmers, except that the “crop cycle” appears to be longer, perhaps two years. These firms will borrow or sell equity one year and then drill for sixteen to twenty-four months. Production will surge two years later and then, as many authorities have noted, fall off rapidly. Related: Analysts: Permian Oil Output Set To Double By 2023

These firms will also enter into hedges as soon as the size of their new discoveries is delineated. The futures sales will likely occur when wells are completed and before they are fracked to ensure the company can cover costs and perhaps profit, even if prices fall.

Data on the issuance of debt and equity by shale firms and their positions in futures markets thus provide an indicator of their future production. These data today point to a large decline in output.

A February 24 Wall Street Journal article by Bradley Olson and Rebecca Elliott should warn everyone of the impending slowdown. A key graph presented there shows that debt and equity issued by US shale producers declined to $22 billion in 2018, which is less than half the amount raised in 2016 and one-third the amount raised in 2012.

When one compares the total debt and equity issuance to Lower-48 onshore production lagged two years, one finds a close relationship. Lower-48 onshore output rose from three million barrels per day to 8.5 million barrels per day in 2018. However, the drop in the issuance of equity and borrowing suggests this production could fall by a third to six million barrels per day by the end of 2020 if the relationship holds.

The activity in the futures markets points in the same direction. Figure 1 compares the rise in US oil production in the five major fracking areas (the Permian Basin, the Bakken, Eagle Ford, Haynesville, and the Julesburg Basin) to open interest in WTI futures. Note that open interest began to decline in late 2013. The production decline began eighteen months later. Related: Blackout Shuts Down Venezuela’s Oil Exports

(Click to enlarge)

The decrease in open interest anticipated the future drop in production. In our view, drilling firms that were forced to curtail activity also curtailed sales of future production, understanding that they would produce less.

These declines were mirrored by a drop in the short position of swap dealers—the financial institutions that write bespoke hedging instruments to producers. The reduction in hedging in 2014 and 2015 led to the later decrease in production.

The same phenomenon is occurring today. Total open interest has fallen by twenty percent, as can be seen from the figure. Swap dealer short positions have also contracted. The message is clear: producers are hedging less, and they are hedging less because they expect to produce less.

The statistics point to a one to two-million-barrel decline in production from the frackers. Some but not all this loss may be made up by the increased activity of firms such as Exxon. In short, the growth in US oil output is about to be reversed.

PS: Further details will be posted here on Monday afternoon.

By Philip Verleger for Oilprice.com

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  • Antoniomerino on March 11 2019 said:
    Good analysis, if you look at
    The profitability of the independent oil companies as a group they havenâ??t had positive net income but one quarter
    In the last three years so they depend on banking and private equity investment that havenâ??t made much money from them. Let see the slowingdown of the rate of production growth during 2019 with an expected capex lower than in 2018
  • Mamdouh Salameh on March 12 2019 said:
    Philip Verleger’s analysis about a projected decline in US oil production ranging from 1-2 million barrels (mbd) mostly from US shale oil production by 2020 is simply brilliant, objective and eye-opener.

    Contrast this with the hype masqueraded as research and analysis coming out from the likes of the International Energy Agency (IEA) saying that US oil production in 2025 will be bigger than the combined production of Russia and Saudi Arabia or Rystad Energy boasting that the United States will overtake Saudi Arabia in oil exports at a time when US oil imports amounted to 9.6 mbd in 2018.

    I have always maintained that the US shale oil industry is one with diminishing returns and therefore will never be profitable. It has been borrowing billions of dollars to continue production just to remain afloat. Since its actual inception in 2008, it has been in a vicious circle. It has to continue production to remain afloat and without borrowing it can’t continue to produce thus amassing huge debts estimated in hundreds of billions of dollars and being unable to pay meaningful dividends to its investors.

    The Achilles heel of the US shale oil industry is the steep depletion rate ranging from 70%-90% in the first year of production necessitating the drilling of thousands of wells just to maintain production. It is estimated that US shale producers need to drill some 10,000 new wells every year at an annual cost of $50 bn just to maintain production. That adds year after year to their fast-growing debts.

    Wall Street investors have been aware of this situation since the beginning of shale oil production. But major investors hoped that shale companies would scale up, achieve efficiencies and lower break-even prices to the point that they could turn a profit.

    Moreover, investors are now calling on shale producers to stop spending so much and instead return cash to shareholders. That leaves less capital available to inject back into the ground. The shale oil revolution was only possible because cheap money in the aftermath of the post-2008 financial crisis financed the debt-fuelled shale revolution.

    Supermajors like ExxonMobil, Chevron and Shell have the resources to plan long-term and can therefore take a long view since their financial survival is not dependent on the Permian like the small independent drillers.

    And despite a spate of highly authoritative reports from credible sources of a slowdown in production in the Permian which is the best shale play in the United States and which accounts for more than 60% of total US shale production, the US Energy Information Administration (EIA) is projecting that US oil production will average 12.4 mbd in 2019 compared with 10.9 mbd in 2018 and averaging 13.2 mbd by 2020.

    The US shale oil industry could become a diminished presence in the global oil market if not a thing of the past within 5-10 years.

    Dr Mamdouh G Salameh
    International Oil Economist
    Visiting Professor of Energy Economics at ESCP Europe Business School, London
  • Buddy on March 12 2019 said:
    I liked your article... I wonder if an oil company would hedge
    Their production if they expected prices to rise, you can leave an awful lot of money on the table when you de-risk...
    Thanks
  • Craig Woerpel on March 12 2019 said:
    Good analysis indeed. I hadn't seen that Figure 1 before. However, Philip touched on the difference from 2014 in his last sentence. The majors don't have to borrow to increase production like the independents do and we have all read how Exxon, Chevron, and Conoco are moving into the Permian. So his predicted drop off might happen or might not.
  • Duane McCarrel on March 12 2019 said:
    Dr Mamdouh loves this article because he still refuses to believe that a bunch of small independent American oil companies can out produce his Arab countries. His constant doom forecasts never materializing and those frackers just keep drilling. He must hate the fact that the Saudi's had to give up trying to run the frackers out of business and were finally forced to cut their production or face running massive losses to sustain their standard of living.

    There are some issues with the data presented in this article. Onshore US production did not rise from 3MM to 8.5MM bbls in 2018. Lower 48 production was a little over 9MM bopd at the start of 2018 and rose to a little over 11MM at the end of the year. Even if you carve out the offshore GOM production, his numbers are way off.

    If anything makes one wonder if the frack boom is coming to a close, it is the likes of ExxonMobil and Chevron now entering the shale fracking fray. They have a way of sucking all the available resources and their presence will bring the legions of social environmentalists. God help those frackers.
  • Timothy Brendle on March 15 2019 said:
    Interesting article, but wouldn't the amount of necessary borrowed capitol decrease as the companies Bakken/Eagleford and Permian assets become more mature and operational cash flow increases?
  • Heng King Chee on April 11 2019 said:
    Isnt the efficiency of the shale wells increasing by more than 20% each year? The major listed shale companies werent profitable either during the first few years. Look at them now, almost all of them have started to turn a profit.

    All the shale doomsayers have turned out to be wrong. In a big way.

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