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U.S. Drilling Activity Inches Up

U.S. Drilling Activity Inches Up

The total number of active…

Matthew Smith

Matthew Smith

Matthew Smith is Oilprice.com's Latin-America correspondent. Matthew is a veteran investor and investment management professional. He obtained a Master of Law degree and is currently located…

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Will Saudi Arabia’s Surprise Production Cut Backfire?

Saudi riyals

Global energy markets and industry insiders believe that it was a good idea for Saudi Arabia to slash oil production by one million barrels daily until the end of March 2021. While it certainly helped to buoy short-term oil prices and spark a sense of optimism regarding the outlook for oil prices, which were severely impacted by the fallout from the COVID-19 pandemic, it may not be as favorable as initially believed. The surprise cut allowed a new OPEC Plus production agreement to be established after initial discussions failed because some participants, notably Russia and Kazakhstan, wanted to increase their petroleum output. By implementing the cut, the cartel’s oil production for January, February, and March 2021 will average 22.119 million barrels per day, a 13.6% decrease compared to the 25.6 million barrels per day pumped during 2020.  When the cut was announced oil prices soared, gaining 10% since the start of 2021 leading to claims of a sustained rally and higher prices ahead. Higher crude oil prices will benefit OPEC members because their economies and government finances are highly dependent on petroleum prices and exports. A key beneficiary is the world’s third-largest crude oil producer Russia. Not only does Moscow benefit from higher oil prices, because of Saudi Arabia’s significant production cut, but can increase oil output during February and March 2020. During January 2021 Russia, according to the deal, can pump on average 9.12 million barrels of crude daily, which incidentally is the same as Saudi Arabia. In February 2021, Russia is permitted to increase production by 0.7% to 9.1 barrels daily, and then another 0.7% for March to 9.24 million barrels daily. 

By slashing production Riyadh risks losing market share at a time when non-OPEC countries are ramping-up oil operations. This includes South American nations Guyana, Brazil, Colombia, and Argentina which see higher oil output as a means of strengthening economic growth to mitigate the fallout from the COVID-19 pandemic. As their oil production expands, they will fill the supply gap left by Saudi Arabia, particularly Brazil which has experienced strong demand growth from Asia for its medium-grade sweet crude oil varieties. Brazil finished 2020 as the fourth-largest supplier of crude oil to China, a slot previously filled by Angola whose oil exports declined because of reduced production due to eventual compliance with its OPEC’s quota.

Related: Russia Is The Biggest Winner In The OPEC+ Deal

A significant beneficiary of Riyadh’s decision is the U.S. shale oil industry. It was the shale oil boom that eventually catapulted the U.S. to first place among global oil producers. During 2018 the U.S. produced on average 10,964 barrels daily overtaking Saudi Arabia’s 10,317 barrels per day, securing the top spot as the world’s largest oil producer. Even sharply weaker oil prices and a prolonged global supply glut did little to crimp the growth of U.S. shale oil. There is every sign that shale drillers will ramp up drilling activity to capitalize on higher oil prices. The Baker Hughes rig count shows there were 378 active drill rigs in the U.S. as of Friday 22 January 2021. That is five greater than a week earlier and 134 rigs higher than the 2020 bottom which occurred in mid-August. Steadily falling breakeven prices for U.S. shale formations, which now average $46 to $52 per barrel according to the Federal Reserve Bank of Dallas, coupled with firmer oil prices have spurred on increased drilling activity. This indicates that drilling activity is already rising despite calls by industry insiders for restraint. The U.S. shale oil industry has a long history of unchecked growth with companies focused on maximizing cash flow by quickly bringing new production online when oil prices rise. Even sharply weaker oil prices after the August 2014 oil price collapse which eventually saw WTI drop below $30 per barrel did little to crimp industry growth. 

It was widely speculated, even before the latest OPEC Plus deal and subsequent oil price rally, that lower breakeven prices would spark renewed drilling activity in the Permian and other major shale oil basins. The largest operator in the Permian Basin, Occidental Petroleum, appears likely to continue drilling despite weaker oil prices. In September 2020, Colombian national oil company Ecopetrol, which has a joint venture with Occidental, announced plans to drill 100 Permian wells during 2021. Oil supermajor ExxonMobil stated during October 2020 that it intends to boost Permian oil production despite slashing costs and reducing its workforce. The volume of operational drill rigs in the Permian has been steadily growing since hitting a 2020 low of 116 rigs in mid-August 2020 to 188 operational rigs as of last Friday.

Related: A Glimmer Of Hope For Oil Markets

For an industry under considerable pressure from investors and bankers to generate cashflow, meet financial obligations and generate returns, it is difficult to see operators taking a restrained approach. It should be remembered that the U.S. shale industry endured a multi-year oil price slump in relatively good shape because of falling breakeven prices. Those developments coupled with greater operational flexibility, improved technology, and slimmer operational structures have made the industry particularly nimble. That means U.S. shale can quickly ramp-up activity and drill new wells. There is a large volume of drilled uncompleted wells, notably in the Permian which according to EIA data had 3,524 DUCs at the end of December 2020. DUCs are quicker to complete and bring online than a normal well, which from site selection to fracking can take up to 90 days. The large inventory of DUCs, which according to EIA data totals 7,298, means shale oil production can be swiftly increased. For these reasons, the U.S. shale oil industry will ramp up drilling activity and ultimately production in response to higher oil prices. Ed Crooks, Vice-Chair Americas at Wood Mackenzie said: 

“Yet despite all the compelling arguments for restraint, the industry’s history suggests that increased cash flows generally get k,turned very quickly into new wells,” 

China’s demand for U.S. oil imports is swiftly increasing. For the first 11 months of 2020 U.S. crude oil exports to the world’s second-largest economy grew two and a half fold to almost 16.2 million metric tons. That ranks the U.S. as the ninth-largest supplier of oil to China making it responsible for supplying just over 3% of the country’s total petroleum imports. Saudi Arabia’s production cut saw Asian buyers rushing to secure other sources of crude oil seeing record North Sea cargoes being bought, while demand for Russian Urals grade crude oil has soared. There are many crude oil producers eagerly eyeing how to fill the supply gap created by Saudi Arabia’s production cut. U.S. shale oil producers are uniquely positioned to fill the gap. A key reason for the sharp increase in U.S. crude oil cargoes being sent to China was the rapidly growing demand for light sweet crude oil. WTI Midland has an API gravity of 40 to 44 degrees and an extremely low sulfur content of less than 0.2%, making it highly suitable for refining into high-quality low sulfur content fuels including IMO2020 compliant marine bunker oil. Whereas Saudi Arabia’s principal export crude oil grade Arab light has an API gravity of 33 degrees and 1.77%, it is particularly sour making it less attractive for Asian refiners seeking low sulfur content crude oil. The U.S. shale oil industry will likely surprise energy markets once again during 2021, with annual production potentially being higher than the 11.1 million barrels daily predicted by the U.S. EIA.

Saudi Arabia’s surprise decision to shoulder the burden of OPEC plus production cuts by slashing one million barrels daily off its crude oil output for three months has buoyed oil prices at a critical time when COVID-19 lockdowns and travel restrictions are severely crimping oil demand. The decision could very well be a blow for Riyadh. Not only does it indicate that the Saudi’s finally recognize their strategy of opening the spigots to drive down oil prices and force U.S. shale producers out of production has failed, but it threatens the country’s market share. U.S. shale oil producers will not exercise restraint nor ignore the ability to bolster urgently needed cash flow by taking advantage of higher crude oil prices and boosting production. Many U.S. drillers were already contemplating expanding production to cash in on lower breakeven prices for new shale oil wells and growing crude oil demand triggered by COVID-19 vaccines and U.S. economic stimulus. While the surprise cut has given Saudi Arabia greater pricing power, reduce fiscal pressures and likely curried favor with Biden’s new administration, it will lead to a loss of market share and greater global oil production. The long-term fallout for Riyadh could far outweigh the short-term gains.


By Matthew Smith for Oilprice.com

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