Art Berman Newsletter: December 2020 (2020-11)

Saudi Arabia surprised oil markets this week by announcing it would unilaterally cut production by 1 mmb/d. This is because oil demand will probably be weaker than previously expected with new Covid spread and its effect on economic activity. It also reflects an over-emphasis on demand when supply is in fact what drives oil markets.

Almost all world supply growth since 2011 has been from the United States (Figure 1).

U.S. production has fallen from almost 13 mmb/d in late 2019 to below 10.5 mmb/d in October 2020 (Figure 2). EIA forecasts an increase in November to 11.2 mmb/d and then an average level of about 11.1 mmb/d for the rest of 2021.

EIA’s forecast does not properly account for the low level of drilling and the high decline rates for U.S. wells. It seems more likely that production will drop by at least a million barrels per day below October’s level later in 2021. If that is the case, perhaps Saudi Arabia’s 1 mmb/d cut is unnecessary.

When prices and rig counts collapsed in 2014-2015, U.S. oil production fell -1.1 mmb/d (-11.6%) (Figure 2). Some believe that is a reasonable model for what has happened in 2020.  It is not. Production has fallen more than twice as much this time even after output recovered from the shut-ins during April and May.

That is because decline rates have changed. In 2014, U.S. decline rates were about 22% annually. Today, decline rates have increased to 43% (Figure 3). Also, the production base is 80% higher than in 2014 so more wells are required to maintain output.

Many analysts expect production to follow a trajectory similar to EIA’s forecast in Figure 2 although at a level somewhat lower than an average 2021 level of 11 mmb/d. That is improbable because reduced rig count has not yet affected production. Most of the decline so far is because of the anomalous number of abandoned or suspended wells.

The number of active U.S. wells has fallen by more than 34,000 (-12%) since August 2019 (Figure 4). Active wells only fell by 8,800 (-3%) from April 2015 to March 2016 during the last price collapse. Most of the decrease is from wells with first production before 2015. That suggests that these wells were producing at relatively low rates that could not cover operating expenses at today’s oil prices. The graph indicates that something similar happened in 2015-16 but the rate today is four times higher suggesting something more consequential behind the abandonments.

Figure 5 shows three scenarios and EIA’s production forecast for 2021.  In the base case, output begins to decline in earnest in April 2021 and decreases to 9.1 mmb/d by September 2021. In the low case the production minimum is estimated at 7.8 mmb/d and in the high case, 9.9 mmb/d.

EIA’s estimate ignores the dramatic drop in rig count. The biggest problem with its model is the assumption that well start to first production is two months.

“EIA estimates that the lag between price signals and changes in rig activity is typically four months, and changes in production take an additional two months to manifest (six total months from a change in price to a change in production.”

This reflects EIA staff’s lack of experience in the oil and gas industry. It also indicates a lack of diligence. Data shows that for 2019, the production-weighted average from well start to first oil production was about 4 1/2 months. It further shows that the average lag from first oil to offset of legacy production decline is about 7 months.

All forecasts are wrong and I do not expect that the three scenarios shown in Figure 5 will be right either. They do, however, represent reasonable form-line projections based on available data.

Whatever the magnitude of production decline or its precise timing, it is important to recognize what is coming. The lower-for-longer ruling paradigm has been accurate and useful since the oil-price collapse in 2014. What is happening now is different.

It is unlikely that the tight oil business will recover from its 2020 body blow. Saudi Arabia’s decision to cut production by 1 mmb/d tacitly acknowledges that it is unconcerned that higher prices will result in a resurgence of U.S. output.

Most do not see WTI prices in the $60 to $70 range as likely in 2021 but I do unless the pace of U.S. drilling increases soon.