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Commodity Investing

Why U.S. Oil Production Is Going Down (And Prices Could Go Up)

Despite what you may have heard in the press, U.S. crude oil production went down in May.

That’s right… down.

It’s expected to continue to slip through the first half of 2016 before resuming its upward climb. Just as my good friend John Hofmeister, former president of Shell Oil, predicted in February.

I’ll get to why John was so spot-on with his prediction in a moment. But first, let’s look at what’s happened since then…

A 44-Year High

In the first half of this year, average daily crude production in the U.S. increased by 300,000 barrels to 9.6 million barrels.

It did this even in the face of a 60% decline in U.S. oil rigs.

In April, our total output was even higher. Production reached a 44-year high of 9.7 million barrels per day (bpd).

US Field Production of Crude Oil chart

However, at the same time, onshore production began to decline…

Flash-forward three months and that decline has steepened. In fact, it’s now offsetting the few additional wells that are coming online.

How can that be?

Let’s get back to Hofmeister’s prediction. The reason the decline is picking up steam is actually due to a natural phenomenon… the decline rate of oil and gas wells.

Keeping Pace

You see, the natural decline rate for a conventional oil or natural gas well is about 5% per year. However, the natural decline rate for a shale well varies from well-to-well and field-to-field. But it can be as high as 30% per year.

The Energy Information Administration (EIA) developed a sophisticated program called the National Energy Modeling System. This system analyzes decline curves from all the major shale plays in the U.S.

The EIA uses this data to determine the expected ultimate recovery from all the different shale plays in the U.S.

There are three key parameters for a decline curve: initial production rate (bpd produced in the first 30-60 days), initial decline rate and the degree of curvature in the curve itself.

Here are typical shale oil well decline curves for the Bakken and Three Forks fields…

Bakken and Three Forks Type Oil Well Decline Curves in North Dakota chart

As you can see from the chart, decline rates for Bakken wells are huge for the first year and drop by more than half during the second year. Other basins have different decline curves, sure, but overall initial production still drops significantly during the first two years.

Just drilling enough wells to replace the ones in decline will only keep production even. In order to grow production, exploration and production (E&P) companies need to constantly increase the number of well completions.

That’s the kicker because that’s not what’s happening. It’s the reason U.S. onshore production is in decline and is going to stay that way for at least a year…

The Expensive Part

You see, E&P companies aren’t completing as many as 60% of the wells they’re drilling. There are about 4,000 of these unfinished projects in the major oil plays.

Why? Because completing a well is the expensive part. Fracking rocks… cleaning out the well… plumbing the wellhead… this is all part of the completion process.

It’s getting a lot cheaper to drill wells with new equipment. But with oil priced between $50 and $60 per barrel, the cost to complete them is hard to justify.

Many U.S. shale plays simply don’t work at these prices.

The good news is, when oil prices hit $70-$80 per barrel, there is a lot of inventory ready for completion.

In the meantime, we are going to see several mergers and acquisitions this year because some E&P companies are too saddled with debt to pump more oil… which is exactly what they need to do. They are truly between a rock and a hard place.

According to the latest EIA figures, 2014 world oil production outside of OPEC rose 2.3 million bpd. This year, it’s expected to increase by just 1.4 million bpd… and a measly 200,000 bpd in 2016.

Most of that will be due to a drop-off in U.S. production. However, Russian oil production is also expected to decline by at least 100,000 bpd in 2016.

This has a lot to do with our sanctions on Russia after its meddling in Ukraine’s business. Foreign investment in Russian oil projects is almost at a standstill due to sanctions.

The bottom line? Maybe stay away from most E&P companies, at least for now. Once prices return to $70-$80 per barrel, many more will be able to grow their businesses.*

While you wait, pipeline master limited partnerships are still my favorite energy investment. They have little exposure to price variations, and they often have fantastic yields.*

Good investing,

Dave Fessler

*Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position of Wall Street analysts.


About

As a degreed electrical engineer, Dave served as vice president of two successful tech businesses: LTX Corporation and Quality Telecommunications Inc. He now provides unique and groundbreaking insights into the energy sector. His new book, The Energy Disruption Triangle: Three Sectors That Will Change How We Generate, Use, and Store Energy, quickly became a best-seller. Dave is the Energy and Infrastructure Strategist for the Profit Trends free daily investment e-letter.

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