One month ago, as we pounded the table on the biggest threat to the fundamental case for oil, namely that even a modest rebound in oil prices could unleash another round of production by the "marginal", US shale oil producers, we warned that a rebound in the price of oil as modest as $40 per barrel, could be sufficient to get drillers to resume production.
As noted in late February, among the companies prepared to flip the on switch at a moment's notice are Continental Resources led by billionaire wildcatter Harold Hamm, which said it is prepared to increase capital spending if U.S. crude reaches the low- to mid-$40s range, allowing it to boost 2017 production by more than 10 percent, chief financial official John Hart said last week. Then there is rival Whiting Petroleum which may have stopped fracking new wells, but added it would "consider completing some of these wells" if oil reached $40 to $45 a barrel, Chairman and CEO Jim Volker told analysts. Then there was EOG Chairman Bill Thomas who did not say what price would spur EOG to boost output this year, but said it had a "premium inventory" of 3,200 well locations that can yield returns of 30 percent or more with oil at $40, and so on, and so on.
The reason for the plunging breakeven price? The same one we suggested on February 3: surging, rapid efficiency improvement which "have turned U.S. shale, initially seen by rivals as a marginal, high cost sector, into a major player - and a thorn in the side of big OPEC producers."
To be sure, while many had expected low oil prices to curb output, virtually nobody had predicted that even a modest jump in oil (when we wrote our article on February 29 oil was at $33, just $7 from the $40 threshold) would lead to a major portion of US shale going back on line. The threat of a shale rebound is "putting a cap on oil prices," said John Kilduff, partner at Again Capital LLC. "If there's some bullish outlook for demand or the economy, they will try to get ahead of the curve and increase production even sooner."
However, the cap was not big enough, because late last week driven by the relentless short squeeze and the sliding dollar, WTI soared well over $40 hitting a fresh 2016 high.
And, as warned, with oil surging above the critical $40 new "floor" price, as Reuters put it moments ago, "a dreaded scenario for U.S. oil bulls might just be becoming a reality."
What exactly is this scenario?
According to Reuters, some U.S. shale oil producers, including Oasis Petroleum and Pioneer Natural Resources Co, are activating drilled but uncompleted wells (DUCs) in a reversal in strategy that threatens to bring more crude to a saturated market and dampen any sustained rebound in prices.
When oil prices started their long slide in mid-2014, many producers kept drilling wells, but halted expensive fracking work that brings them online, waiting for prices to bounce back.
But now, with crude futures hovering near multi-year lows and many doubting recent modest gains that brought oil prices near $40 a barrel can hold, the backlog of DUCs is already shrinking in some areas. In key shale areas such as Eagle Ford or Wolfcamp and Bone Spring in Texas such backlog has fallen by as much as a third over the past six months, according to data compiled by Alex Beeker, a researcher at Wood Mackenzie.
"If the number of DUCs brought online is surprising to the upside, that means U.S. production won't decline as quickly as people expect," said Michael Wittner, global head of oil research at Societe Generale. "More output is bearish.”
In the Wolfcamp, Bone Spring and Eagle Ford, the combined backlog of excessive wells remains around 600, Beeker estimates. About 660 wells could be the equivalent of between 100,000 and 300,000 barrels per day of potential new supply, according to Ed Longanecker, president of Texas Independent Producers and Royalty Owners Association (TIPRO)
This goes to what we warned about in the start of February when we said that "Another Leg Lower In Oil Coming After Many Producers Found To Have Far Lower Breakevens."
And with its usual 2-4 month delay, the market is finally starting to realize just this.
As expected, Reuters writes that for now, most of the wells are activated in Texas, where proximity to refiners allows producers to sell their crude closer to benchmark prices, and by well-hedged companies that have locked in higher prices.
Still, the pace of fracking of the uncompleted wells may quicken if cash-strapped producers facing debt repayments can no longer afford to store their oil in the ground.
While the potential additional supply is a fraction of total U.S. production of around 9 million bpd, the fresh flow would reinforce concerns about a growing global glut just as Iran ramps up output and inventories in domestic storage tanks from the Gulf to Cushing, Oklahoma, test new highs on a weekly basis.
But back to the DUCs, which are a new development for many of the algos which have been trading oil on nothing but momentum:
Wood Mackenzie reckons that the backlog of excess DUCs will decline over the next two years, and return to normal levels by the end of 2017. It is expected to fall 35 percent from current levels in the Bakken and 85 percent in the Eagle Ford by the end of 2016. With service costs down, now is a good time to bring a well online if a company has hedged its production and covered its costs, said Jonathan Garrett, an analyst with Wood Mackenzie. The U.S. crude breakeven for such wells is one-third lower than for new ones, according to Wood Mackenzie.
Typically, average DUC inventory is around 550 in the Wolfcamp/Bone Spring formations and around 300 in the Eagle Ford, Beeker estimates. Rival Oasis is also focusing on drawing down its backlog this year, executives said during the company's last earnings call.
In each of those formations, the excess has fallen by about 150-175 over the past six months, bringing the surplus to around 300 wells in each. "We're just going to be continuously completing the wells there (in the Permian) with our fleets and so you will not see any DUCs in Midland basin," Pioneer Chief Operating Officer, Tim Dove, told a recent earnings conference.
And then the story verges off to something else we have warned about, namely soaring hedging as oil has rebounded, allowing producers to lock in profits even in case oil should once again resume sliding from this price. Both Pioneer and rival Oasis have locked in future sales at prices well above current levels. Oasis has 70 percent of its oil production for 2016 hedged above $50 a barrel and roughly 20 percent of its 2017 production hedged at about $47 a barrel. Similarly, Pioneer has locked in a minimum price for 85 percent of this year's production.
To be sure, not everyone will be able to ramp up production: in North Dakota, the second-largest oil-producing state where producers like Whiting Petroleum Corp sell their oil at steep discounts, it might not be economic Reuters calculates. There, the number of DUCs climbed above 1,000 in September before falling to 945 in December, according to the latest data from the state's energy regulator.
Bakken producer Continental Resources Inc which made waves when it unwound its hedges in late 2014, has said it would continue to defer completions until prices rise. Bakken discounts were just too steep, said Garrison Allen, a research associate at Raymond James. "It doesn't make sense to do anything up there."
But not everyone is needed to ramp up production: even if shale output rises by just a few hundred thousand barrels in the short term, that will be enough to push the US storage situation, already at critical point, into beyond operation capacity levels, and lead to dumping of oil in the open market, resulting in the next major leg lower in oil prices, which in turn will spillover into energy stocks and the broader market, and force central banks to consider what until recently was merely a joke, namely monetizing crude in the open market. After all, at this point when central banks have lost all credibility, why not?