Oil: Is Climbing U.S. Production About to Peak?

The number of operating oil rigs plateaued at just over 750 in July, according to data from oil services provider Baker Hughes.  This by itself may point to a decline in U.S. oil production. However, it takes, on average, about four months or so for an oil rig to begin producing significant amounts of oil – although time lags can be vary considerably depending upon the equipment and the field.  And, there are about 100 more rigs operating today than there were four months ago.  This suggests the possibility of some further upside for oil production over the next few months. 

What is more concerning is the collapse in marginal rig productivity.  When the oil market began to rise last May, the energy industry deployed its best equipment to its most promising fields.  Initially, each additional rig contributed 6,000 barrels of oil per day within four months to U.S. total production in excess of the depletion rate.  As time went on, the number of rigs soared and U.S. production continued to rise.  But by February of this year, the marginal productivity of each new rig fell by about 75%; each new rig was adding only about 1,400 barrels per day in excess of the depletion rate.  This reflects both the short-term nature of many of the shale plays, with fast rises and quick declines in oil production as well as the fact that the energy industry had been deploying less advanced equipment to less promising fields as much of the low hanging fruit had already been picked.

As such, the 100 or so oil rigs that have been added over the past four months might add (optimistically) 150,000 additional barrels per day to U.S. production.  This surge in production is still making life difficult for OPEC but U.S. production may soon peak again at around 9.75 million barrels per day, matching but not exceeding its level from the summer of 2015. 

For an indication of when U.S. production might begin to decline, look at both the rig count as well as the marginal productivity of additional rigs.  Rig counts stopped increasing when oil prices fell back below $50 per barrel.  Now that prices have recovered a little, it will be interesting to see if the energy industry responds by deploying more equipment.  Even if it does, however, it will not be a guarantee that U.S. production will continue its rise.  For that to happen, the rigs have to produce more oil than is being depleted from existing wells – both traditional ones and in fracking.

U.S. production could be on the decline again within a few months, and if that turns out to be the case, it will be bullish for oil, all else being equal.  The good news for consumers and others hoping for lower energy prices is that all else is not equal.  OPEC is notorious for not complying with production cuts and could eventually throw in the towel on curbing output.  Already, cracks are appearing in the organization.  On the upside for oil prices are issues of political stability: Venezuela is rapidly descending into chaos and is far from the only oil-exporting nation with the potential for instability.

• U.S. rig count has stopped rising.
• Marginal rig productivity is in steep decline as drillers struggle to exceed the depletion rate of existing wells.
• U.S. oil production could peak soon and begin to fall again.
• This could be bullish for oil prices but only if OPEC complies with output cuts.
• OPEC is likely to bust through its production limits.
• Venezuela’s political instability could push prices higher.
• Other oil exporters (notably Algeria, Angola, Iraq, Libya and Nigeria) have the potential for instability as well.
• The U.S. remains the most important swing producer of oil.
• U.S. inventories have begun to decline for the first time in three years, a potentially bullish factor over the long-term but not necessarily in the short-term.