QT is good for OPEC

SEB - Prognoser på råvaror - CommodityIt is quite clear that the strong rebound in US shale oil production since early 2016 has been fuelled by access to cheap and easy money derived from the world’s central banks QE programs. It is not to say that US shale oil is not viable at the right price. US shale oil business has however been running at negative cash flow year after year with growth being bankrolled by investors. Not even in Q3-18 this year when Brent averaged $75.8/bl and WTI averaged $69.5/bl did they in total have positive cash flow. Since the start of 2017 the three main US shale oil producers (EOG, Continental Resources and Pioneer Natural Resources) have had an average negative equity return of -13% while Equinor has yielded +21% and S&P 500 has yielded +16% to end of Friday last week.

Bjarne Schieldrop, Chief analyst commodities at SEB

Bjarne Schieldrop, Chief analyst commodities

Quantitative tightening is now blowing out credit spreads. US high yield junk rated credit spreads have jumped to 5.5% over investment grade in Q4-18. Not a single company in the US has been able to borrow money in the $1.2trn high yield market so far in December which is the worst since November 2008 according to FT today. So easy money is rapidly drying up for US shale oil players which means that they will likely have to run disciplined according to cash flow. That implies much softer US shale oil production growth in a market where the high yield US junk bond energy credit market is closed and Brent and WTI prices are $60/bl and $51/bl respectively.

What matters for US shale oil production growth is US shale oil well completions per month and how much new production they bring that month versus losses in existing production that month. As production has moved higher and higher the running losses in existing production has moved comparably higher as well. At the moment losses are running at a rate of 530 k bl/d/mth. So US shale oil production is losing half a million barrels per day each month. So more and more wells needs to be completed each month to counter this. The net of new production from well completions and losses in existing production is what brings either growth or decline in US shale oil production.

In October US shale oil producers completed 1308 wells. In real, productivity adjusted terms this is the highest level ever and it is 57% higher than the real, average level in the peak year of 2014. But losses in existing production have increased strongly as well.

We have calculated the “steady state US shale oil well completion rate (SSCR)” meaning the number of well completions needed in order for US shale oil production to move sideways. US shale oil production is growing when the monthly completion rate is above the SSCR and it is contracting when it is below the SSCR. In October completions were running at 231 wells (18%) above the SSCR. Completions were however running at a rate of 35% above the SSCR level in September 2017. As a result the marginal, annualized production growth in the US was much stronger in late 2017 than what it is right now. In late 2017 the 6mth average, marginal annualized US shale oil production growth was running at a stunning 1.9 m bl/d/yr. It is still running at a very strong 1.5 m bl/d/yr rate, but the last monthly data point for October (marginal, annualized) was down to 1.3 m bl/d. And that was despite the fact that real well completions were at an all-time-high of 1308 wells.

So more and more wells needs to be completed in order to keep growth going. At current crude oil price levels the US shale oil business is running a negative cash flow and equity owners have lost money since the start of 2017 and the US high yield energy market now seems to have closed. US shale oil well completions are in our calculations running at an 18% completion rate above the SSCR level. So US shale oil players only need to reduce completions by 231 wells ( or 18%) per month to bring the marginal US shale oil production growth rate to zero.

If crude oil prices continue at these levels this is probably exactly what we’ll see: well completions will be brought down to the SSCR level and we’ll have zero marginal production growth in US shale oil production. So far OPEC+ has put a floor under crude oil prices with Brent crude at $60/bl. If we stay at this price the well completion rate will probably be brought down towards the SSCR level and US shale oil production will stop growing for a while. Lower oil prices and lack of credit (due to QT) will now most likely give OPEC+ a helping hand in the market balancing.

Today we’ll have the latest US EIA Drilling Productivity report showing the well completions in November. It will be extremely interesting to see if prices already have started to bite so and the completion rate has started to tick lower from October to November. Losses in existing production have definitely ticked one notch higher since October and the marginal, annualized production growth has probably ticked lower.

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