Huge 300,000 Bpd Fracklog Could Derail Oil Price Recovery

Thousands of drilled shale wells are sitting idle, unfracked and uncompleted.

The backlog of drilled but uncompleted wells (DUCs) grew dramatically beginning in 2014, as low oil prices forced drillers to hold off on completion in hopes of higher prices at a later date. After all, why bring production online in a low price environment when the same oil could earn more in the future if prices rebound. That calculation is particularly important given that a shale well typically sees an initial burst of production in its first few months of operation followed by a precipitous decline in output.

The surge in DUCs created an enormous backlog of wells awaiting completion. This "fracklog" loomed over the oil market, threatening to derail any sign of an oil price recovery. As soon as oil prices rebounded to some higher point, the shale industry would bring thousands of already-drilled wells online, and that sudden rush of new supply would push prices back down.

But that was a necessary process in order to shrink the huge inventory of DUCs - and that's exactly what started to play out last year. As oil prices moved up from $27 per barrel in February 2016 to around $50 per barrel by early summer, the industry began completing a lot of wells. The DUC inventory fell from over 5,600 to just over 5,000 between January and August, a decline of 10 percent, according to the EIA's Drilling Productivity Report.

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By late November, when OPEC announced an ambitious plan to take 1.2 million barrels per day off of the market, combined with nearly 600,000 bpd of non-OPEC cuts, oil prices shot up. One would have thought that the DUC inventory would see another round of completions, reducing the backlog even further. Related: The Wealthiest Oil & Gas Billionaires In The U.S.

But that didn't happen. The DUC list has grown since then, increasing to 5,443 as of February 2017, an increase of roughly 8 percent since October. Why did this happen even though WTI and Brent moved up well into the $50s per barrel? The rig count has increased sharply since the OPEC deal was announced, but why are companies adding rigs back into operation if they are not completing the new wells that they are drilling? For example, in the Permian Basin, the industry drilled 395 new wells, but they only completed 300 of them.

Reuters interviewed industry experts and lawyers and found that a lot of companies are drilling new wells because the terms of their leases require drilling by a certain date or else the companies forfeit their rights to the acreage. Standard leases typically have three-year terms, Reuters says, with an option for a two-year extension. They can drill the wells, but keep them uncompleted and still comply with the terms of the lease, allowing the companies to hold onto the acreage and then come back at a later date to complete the well.

Holding onto land is particularly important these days because land prices in West Texas have skyrocketed, with acreage costing five times as much as it once did a few years ago. Nobody wants to forfeit any prospects amid such a land rush.

Another element contributing to the DUC buildup is that market for fracking crews is tightening, according to Reuters. After a well is drilled, producers contract with fracking crews to complete the well. Related: Saudi Aramco IPO Under Pressure, As 9/11 Lawsuits And Oil Prices Hit

"There were a number of completions that were originally scheduled in first quarter and you've seen those slide to Q2 and that's really being driven by...access to service crews and things like that," Tom Stoelk, the CFO and interim CEO of Northern Oil & Gas Inc, told Reuters. So the uptick in the backlog could just be temporary.

But with drilling activity picking up, oilfield services companies are seeing such an uptick in demand that they are charging more. The rising cost of frac sand, well completions, drilling rigs and even labor are leading to cost inflation across the industry, cancelling out some of the "savings" achieved since the market downturn began in 2014. As such, some companies might be waiting for higher prices.

Once the DUCs are completed, new production will come online. And just as before, that backlog still weighs on the market. Wood Mackenzie estimates that if the Permian Basin's DUC list was completed, it would add 300,000 bpd in new supply.

That supply sitting on the sidelines will put downward pressure on any new oil price rally.

By Nick Cunningham of Oilprice.com

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