Barely past the midpoint in OPEC's valiant move to restrain production and accelerate the rebalancing of an oil market reeling under a three-year supply glut, the specter of a resurgent U.S. shale sector has cast a bearish shadow on sentiment and capped crude's price rally.
The story of the "sheikh versus shale" battle is not new. What is surprising is that OPEC's facts -- an unusually strong and improving compliance with 1.8 million barrels per day of output cuts being implemented with non-OPEC collaborators since January -- have been overshadowed by fears of how shale companies will respond.
Exactly how much U.S. production will grow if crude remains in the $50-60 per barrel band is nearly impossible to predict. Arguably the single biggest "known unknown" in the oil market for 2017, it has sparked passionate debate among some industry analysts about whether the bulls -- and OPEC -- are in for a rude surprise from output surging far beyond current expectations. Many also wonder if the potential of the giant Permian Basin is just hype tinged with Texas bravado.
It doesn't really matter. The big problem for the market is not that we cannot accurately predict the immediate future with regard to shale. Rather, it is that OPEC is not strategizing for the single biggest threat to its attempt to actively manage the oil market back into equilibrium: a spike in U.S. production.
More to come
The sluggish depletion of world oil stockpiles, downward adjustments in demand growth forecasts and a slump in bullish bets on crude futures from record highs during the first quarter of this year have shown that an extension of the production cut deals beyond June, which appears all but certain at OPEC's next meeting scheduled for May 25, is the bare minimum needed to keep prices from collapsing back into the $40 range. It is not a counter for the possibility of, say, an 800,000 barrels per day on-year rebound in average U.S. crude production in 2017, accelerating further in 2018.
Hoping for a modest production increase rather than a surge does not qualify as a strategy either.
U.S. output averaged 9.25 million barrels per day in the week ended April 14, up nearly half a million barrels per day compared with the end of 2016, and around 820,000 barrels per day higher than the recent trough of July 2016, according to the latest data from the country's Energy Information Administration.
The EIA is predicting a relatively modest year-on-year growth of around 350,000 barrels per day in 2017 to an average of 9.22 million barrels per day, but it may be erring on the conservative side. A look at its recent history of forecasts shows actual U.S. monthly output figures consistently exceeded the agency's projections.
Meanwhile, a troika of readings might be driving the fear that U.S. production could rebound enough to neutralize the efforts of the OPEC/non-OPEC cutbacks: a continuing strong increase in the number of oil rigs drilling in the U.S., a considerably improved financial environment of the U.S. oil and gas independents, and a major boost in capital expenditure in shale properties earmarked for this year.
Lying in wait
The U.S. had added oil drilling rigs for 13 weeks in a row as of April 13, according to Baker Hughes data, in continuation of a trend of a strong upward incline in rig count since the second half of 2016. The total number of active oil rigs in the U.S. has more than doubled in the past nine months to 683, with most of the additions occurring in shale plays rather than conventional oil fields.
Since November 2016, the month OPEC forged its landmark production curb agreement and sparked a spike in crude prices, U.S. producers have increased the number of wells drilled each month, but they have also been leaving a significant fraction of these wells uncompleted, presumably to be quickly brought onstream as and when the economics become more favorable.
The inventory of the wells drilled but uncompleted, or DUCs as they are commonly referred to, had grown to its highest level in a year at 5,512 as of the end of March in the country's seven biggest shale plays. At what crude prices producers might start bringing these DUCs onstream and how that might spur output is a big unknown.
Capital expenditure by 44 onshore-focused oil production companies jumped $4.9 billion, or 72%, in the fourth quarter of 2016 against the same period in 2015, according to the EIA. This dovetailed with U.S. benchmark West Texas Intermediate crude climbing to an average $49.28 per barrel in the fourth quarter of 2016 from $42.16 in the corresponding period in 2015.
Shale's responsiveness in adjusting output according to crude prices, its relentless technological advancements and drive for greater cost-efficiencies are not the only variables that need to be factored in. An important turnaround story, and one worth keeping an eye on, is the improved financial fortunes and debt environment of the shale producers in recent months.
U.S. independents successfully rotated into the equity markets to raise cash in 2016, as banks progressively reduced credit limits based on the diminishing value of producers' underground oil and gas reserves due to softening crude prices through 2015. Meanwhile, the price recovery since the fourth quarter of 2016 is expected to help some companies increase their bank borrowing this year.
Some of that boost has already begun manifesting, with energy companies raising $26.8 billion in "leveraged loans" -- lending to those already holding large amounts of debt -- in the first quarter of this year, an 86% jump from a year ago, according to Bloomberg data. Flush with cash, the producers are looking to step up spending, which means more drilling and increased output down the line. If the boom does not happen in 2017, it could occur in 2018.
OPEC's goal of ensuring global oil inventories drain down to five-year average levels is the start, not the end, of bringing about a sustainable market equilibrium. It is unimaginable that the 1.2 million barrels per day of curtailed OPEC output could be allowed back into the market even in 2018 to slosh around alongside increased non-OPEC production, principally from the U.S., and not create another glut amid moderate growth in world consumption.
So, what does OPEC need to do? First, it needs to be prepared to run a marathon on production restraint, not six-month sprints. Second, OPEC needs to accept that like prices, U.S. output growth will move inversely to its own production volumes. U.S. producers can neither be threatened nor persuaded to act otherwise. The point at which the bloc achieves its desired prices while offsetting U.S. production growth with its own curbs such that the net increase in supply matches the rise in global demand will be the true equilibrium point. And that will be a dynamic point, not a static one.
Vandana Hari is founder of Vanda Insights, which provides research and analysis on the energy markets.