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Nick Cunningham

Nick Cunningham

Nick Cunningham is a freelance writer on oil and gas, renewable energy, climate change, energy policy and geopolitics. He is based in Pittsburgh, PA.

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$30 Oil Will Accelerate Much Needed Rebound

Oil markets are waiting for a much greater supply contraction before prices rebound, and the deeper downturn in prices will test the current pace of adjustment. With WTI dipping to $35 per barrel, it will likely spark deeper cuts to spending and drilling, which could perhaps contribute to an accelerated pace of adjustment.

In other words, a sharper fall from the mid-$40s per barrel to the mid-$30s per barrel could sow the seeds of a faster rebound than we might have otherwise witnessed.

Although to date the pain has been significant in the upstream exploration and production sector, things are about to get much worse. Hedges continue to roll off, removing the last bit of protection that some drillers have had up until now.

"Producers have survived 2015 as they benefited from large reductions in service costs while having a significant amount of production hedged at high prices," John Arnold, formerly at hedge fund Centaurus Advisors, told Reuters in an interview. “Come Jan. 1, revenues will experience a pronounced decline for many companies, coinciding with a time of severe stress for balance sheets across the industry,” he added.

Related: How Far Will Oil Sink Before Christmas?

Reuters surveyed the 30 largest oil producers, and only five of them actually expanded their hedging program during the third quarter of 2015. The rest saw their hedging positions erode as contracts expired. Eight of them had no hedging protection whatsoever for 2016. Reuters noted the “missed opportunity” when few companies added hedging protection when oil prices rebounded to $60 per barrel in the spring, and then again in September and October when prices rose modestly after a downturn in the summer.

According to Reuters, Devon Energy, Whiting Petroleum, Hess and Denbury Resources are a few of the companies that have seen their hedging positions decline the most.

That will subject them to the full savagery of oil prices flirting with 11-year lows. Without hedging, there is a much lower incentive to drill, as any barrels pulled out of the ground will be sold for much less than they would be under a hedged position. Related: This Oil And Gas Nation Is Doing Something It's Never Done Before

At $35 per barrel, even some of the most efficient shale drillers will struggle to turn a profit. "Nothing is economic at today's prices," James West, an analyst with Evercore ISI, told The Houston Chronicle. Drillers have gone to extraordinary lengths to reduce costs since mid-2014 when prices started to fall. That included focusing on the sweet spots, drilling more and longer laterals from a given wellpad, and even squeezing suppliers. Evercore ISI says that a third of the companies in the oilfield services sector may not survive 2016.

While the efficiency gains succeeded in bringing down costs, even some of the best shale companies are in the red at this point. Evercore ISI told The Houston Chronicle that the average breakeven cost for North American shale used to be $65 per barrel. Efficiency gains brought that threshold down to $50 per barrel. That is an impressive achievement over the course of just 12 to 18 months, but it is still higher than current prices. With drilling services unable to discount their offerings any further, upstream producers will have to cut deeper.

As a result, sharper cutbacks in spending are just around the corner. Cowen & Co. expects the oil industry to slash spending by $115 billion next year compared to 2015 levels. Related: The Hidden Danger Of OPEC’s Market Share Strategy

The fall in the rig count has accelerated in recent weeks after several months of remaining level. Baker Hughes says that the rig count fell by 28 last week, the sharpest decline in three months. That trend should continue with oil prices now at such low levels. With a deeper contraction in rig counts and drilling levels, new production will slow to a trickle. At the same time, depletion from wells drilled months and years ago will continue to mount, dragging down overall production.

In recent months, the Permian Basin has been dubbed one of the last shale regions where companies can still turn a profit. But it will be difficult for production to keep growing even in the Permian with oil prices in the mid-$30s.

Deeper cuts and a sharper slowdown in drilling should add up to an acceleration in oil production declines. Only then will oil prices start to rebound.

By Nick Cunningham of Oilprice.com

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