Why The US Is About To Be Flooded With Record Oil Production Due To Plunging Oil Prices

One would think that plunging oil prices and the resulting mothballing (or bankruptcy) of the highest-cost domestic producers would lead to a collapse in US oil production. And sure enough, if looking simply at headline data like the Baker Hughes count of active rigs in the US, then US oil production grinding to a halt would be all but assured. However, what will actually happen, even as the highest-cost producers and those with the weakest balance sheets are taken to their local bankruptcy court, is that as Bloomberg reports, the US is - paradoxically - set to pump a 42-year high amount of oil in 2015 "as drillers ignore the recent decline in price, pointing them in the opposite direction."

Here is the surprise for all those thinking Saudi Arabia will declare a quick win when half of the US shale is bankrupt and supply plunges: U.S. energy producers plan to pump more crude in 2015 as declining equipment costs and enhanced drilling techniques more than offset the collapse in oil markets, said Troy Eckard, whose Eckard Global LLC owns stakes in more than 260 North Dakota shale wells. That and the scramble to put competitors out of work, before competitors do just that to you.

On one hand oil companies are, logically, shutting down expensive production. However, in borrowing a page from the playbook of the iron ore producers who also are caught in an AMZNian race to the bottom, and are producing more raw materials than ever in hope of putting their competitors out of business as fast as possible, what they are also doing is shifting their focus to their most-prolific, lowest-cost fields, which means extracting more oil with fewer drilling rigs, said Goldman Sachs Group Inc. Global giant Exxon Mobil Corp. the largest U.S. energy company, will increase oil production next year by the biggest margin since 2010. So far, the Organization of Petroleum Exporting Countries’ month-old bet that American drillers would be crushed by cratering prices has been a bust.

In short, what the US energy industry will do at the national level, is precisely what OPEC did as an international cartel: battle plunging prices, and demand, with surge, if not record, production:

“Companies that are already producing oil will continue to operate those wells because the cost of drilling them is already sunk into the ground,” said Timothy Rudderow, who manages $1.5 billion as chief investment officer at Mount Lucas Management Corp. in Newtown, Pennsylvania. “But I wouldn’t want to have to be making long-term production decisions with this kind of volatility.”

Everyone's hope: flood the market with as much cheap oil as possible to take out higher cost competitors, and remove supply as quickly as possible. The problem is that this is precisely what everyone else will also do, and in the biggest paradox of the crude price collapse, the near-term outcome will be an unprecedented surge in oil supply, which will lead to an even greater crash in prices before everything reverts back to a more stable equilibrium... at some point in the distant future.

Some of the facts according to Bloomberg:

  • U.S. oil production is set to reach 9.42 million barrels a day in May, which would be the highest monthly average since November 1972, according to the Energy Department’s statistical arm.
  • Exxon, the world’s biggest oil producer by market value, is expected to boost crude and natural gas output by 2.8 percent next year to the equivalent of 4.1 million barrels a day, based on the average of eight analyst estimates compiled by Bloomberg.
  • Existing wells remain profitable even as benchmark crude futures hover near the $55-a-barrel mark because operating costs going forward are usually $25 or less.

While as we have shown the vast majority of US shale is no longer profitable below $60, when one factors in the entire US energy sector, the average cost to operate an existing well in most parts of the U.S. "is about $20 a barrel," according to Tom Petrie of Petrie and partners. "It might be $5 higher or it might be $5 lower, that’s the out-of-pocket costs that we’re talking about. Until you dip into that and start losing money on a cash basis day in, day out, you don’t think about shutting in” wells.

So what does this mean for the US energy industry: simple - while capital spending and growth projects are about to be frozen for years to come, companies are about to set existing production on turbo Max, as everyone hopes to not only "make up for lower prices with soaring volume", but to take out their immediate competitors before their competitors do just that to them.

And so the race to the bottom truly begins. The only question is will Saudi Arabia's cash reserves last long enough to keep its "bread and circuses" social fund solvent while the US energy sector implodes under its own weight, or if with a little help from outside, something "black-swany" were to happen to Saudi Arabia and/or its production infrastructure.

Then those very deep OTM 2016 Brent calls we bought a few weeks back will seem like quite the bargain.