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Tight oil output expected to decline in 2016

Unless change happens soon, low oil prices will continue to overwhelm tight oil producers, writes Justin Jacobs

While US tight oil output has been more resilient than many expected, production clearly peaked in April this year and has been in steady decline since. Expect those declines to accelerate heading into 2016 unless there is a quick reversal in the oil price, with shale output likely to fall more than 1m b/d from the April peak of close to 5.4m b/d.

A steady flow of cheap financing and strong drilling efficiency gains have been the pillars of the shale industry’s strength – but both are giving way.

Shale spending is down sharply this year, by about 30%, but continued access to low interest and plentiful capital has allowed companies to continue to pile on debt to keep drilling. So for all the talk of belt tightening in the shale patch this year, the sector is still spending more than it is bringing in. Drillers are on pace to have negative free cash flow of around $24bn in 2015, reckons S&P, the credit rating agency. Many thought Wall Street would tighten the spigot to the shale sector in the October round of lending reviews, when banks re-determine companies’ credit lines. It didn’t happen. Rather than the 25% reduction to the industry’s borrowing base, most companies saw their debt facilities cut by less than 10%.

But as the “lower-for-longer” oil price mentality sets in, and many shale companies’ finances continue to deteriorate, the tide is finally turning. Debt markets have largely dried up. US exploration and production companies issued more than $20bn in more than 30 new bond issuances in the first half of 2015, but new debt deals have ground to a standstill since the second oil price plunge in July, according to data from credit rating agency Moody’s. Moreover, many expect Wall Street to be much less forgiving when the next round of lending reviews come in the spring of 2016. E&P companies, it appears, will have to rely on asset sales and more costly alternative financing arrangements, such as deals with private equity and hedge fund investors, until the oil price turns.

With liquidity drying up, another round of steep spending cuts lie ahead in 2016. Most companies haven’t detailed their 2016 spending plans yet, but the announcements to date point to another year of punishing austerity ahead, with the aim for most of achieving free cash flow. Marathon Oil, a major player in the Eagle Ford shale, says it will cut spending by 29% in 2016 to $2.2bn, less than half what the company spent in 2014. Devon Energy could cut spending by as much as 40% in 2016 to $2.7bn. Oasis Petroleum cut its capital spending by nearly 60% to around $670m this year, and has said it could cut by another 40% or so next year to put the company in a position to be free cash flow positive with oil prices at $50/b.

Further expected cost declines will help cushion the blow of these deep spending cuts, but all of this points to another year of sharply reduced drilling activity. The US oil-directed rig count reached a new post-downturn low of 555 in the week of 25 November, a third of what it was in September 2014. Given the bearish short-term price outlook, the rig count could fall further in the weeks ahead.

Through much of the downturn, the industry managed to continue to pump more oil from fewer rigs thanks to huge efficiency improvements. Productivity rose thanks in part to continued technological improvements in well completions, but also simply because companies were drilling on their best land, a process known as “high-grading”. From late 2014 through the summer of 2015, production per rig rates were increasing at more than 4% a month, according to data from the Energy Information Administration (EIA), so even as the rig rate plunged, production continued to rise.

However, the efficiency gains that have been so central to US shale resilience have flat lined in recent months. EIA estimates show no improvement in well productivity in the Bakken from October to December and the Eagle Ford from November to December.

In other words, productivity gains are not offsetting the reduction in rigs, leading to accelerated production declines. And a return to the rapid rate of well productivity improvements seen over much of 2015 is unlikely. Instead, a far slower improvement rate is likely to be seen, reflecting the gradual pace of technology gains without the amplifying impact of high-grading.

The EIA expects output from the Eagle Ford and Bakken to fall by a combined 105,000 b/d from November to December. And production will continue to decline and an increasing rate in the coming months, unless a price rebound sees a turnaround in drilling activity. Analysts at Deutsche Bank expect 100,000 b/d-plus month-on-month shale oil production declines to continue until around March next year. Altogether, the bank expects US shale output to fall by about 1m b/d from just shy of 5.4m b/d April 2015 to less than 4.4m b/d in April 2016, with further declines in the second half of the year. Onshore US production for 2016, Deutsche Bank says, will be around 900,000 b/d less than in 2015.

All of this is bullish for oil markets going into late 2016 and could contribute a much sharper production decline than many are expecting. The IEA, for instance, is forecasting US shale output to fall by 600,000 b/d in 2016. It would also vindicate the Saudi-led Opec strategy of waiting out shale producers.

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