Despite roller coaster ride, oil prices will stay low

With oil prices unlikely to rebound from their steep slide anytime soon, producers all around the world will have to scramble to adjust. U.S. shale drillers are slashing their costs to remain competitive, while OPEC and other big oil exporters are looking for a new strategy to cope with cheap oil, now that they can no longer force prices up by restricting output.

Lately, the oil market has felt like a roller coaster: soaring one moment, plunging the next. But pretty much no one is betting on the price of a barrel of crude returning to $100, the level that had come to seem “normal” until recently. We’re expecting the U.S. benchmark, West Texas Intermediate crude, to average between $45 and $55 per barrel next year. If that pans out, expect to see some big changes in the resurgent U.S. oil industry.

American oil production is already starting to slide because of the price drop. And further cutbacks are all but certain in coming months. According to the latest data from the Department of Energy, crude oil production peaked in April at 9.6 million barrels per day. That’s nearly double the level in 2005, before the combination of hydraulic fracturing and horizontal drilling allowed drillers to tap huge deposits of previously unreachable shale oil. But since April, output has slipped to about 9.3 million barrels per day, according to Uncle Sam’s latest monthly numbers.

The decline is no surprise. According to drilling services provider Baker Hughes, the number of rigs actively drilling for oil in the U.S. is down by 60% from a year ago, when the price slump was just beginning. Wells that may have been quite profitable at $100 per barrel suddenly weren’t worth drilling when the price of crude dipped below $45. So, as older shale wells dry up (something they tend to do quickly), fewer new ones have come on line to make up for the lost output.

But the production boom isn’t over. It’s simply on hold until producers figure out how to cope with the new, low-price environment. Here’s why:

Productivity Push

If a return to high prices isn’t imminent, drillers will have to cut their way to profitability. Drilling wells in shale fields is expensive. So expensive, in fact, that many oil market analysts have long assumed that a sustained price drop would wipe out shale operators in areas such as North Dakota and Texas. But so far, that hasn’t happened. The incentive of low oil prices is pushing drillers to cut costs wherever possible, which has allowed more of them to at least weather the current downturn. Even at today’s price of less than $50 per barrel, many of them can turn a profit.

The cost-cutting drive is just getting started. One Houston-based oil industry consultant, who agreed to speak with Kiplinger’s Energy Alert anonymously, says that drillers increasingly see working in shale as an industrial process, one that can be done faster and for less money. Given how well-explored many of the big shale fields are, he says, “you know there’s oil there.” Now it’s just a matter of getting as much of it as possible, as cheaply as possible.

Call it “shale 2.0.” The name of the game is drilling wells faster, with less down time between jobs to minimize costs, while concentrating on the richest oil deposits and using rigs best suited to that particular geology. Equipment makers are designing drills and other gear based on direct feedback from producers about what works best in a given shale reservoir. Drillers such as Hess, a major producer in North Dakota’s Bakken Shale, liken this approach to the concept of lean manufacturing that Toyota popularized decades ago. (Hess even sent executives to Japan in recent years to study Toyota’s approach to optimizing every step of their manufacturing process.)

The bottom line: more oil from each new well. In its latest Drilling Productivity Report, the Department of Energy estimates that producers in the largest shale plays will extract significantly more crude from a newly drilled well this October than they did last October. In North Dakota’s Bakken field and the Eagle Ford Shale of Texas, those gains are on the order of 50% more. That will cushion the blow from falling rig counts, allowing overall production to decline only slightly despite the sharp drop in the number of rigs working.

Of course, cost cutting has its downsides. Employment in shale country is already suffering and won’t bounce back anytime soon. Running fewer rigs and drilling wells faster means fewer workers are needed to produce a barrel of crude. In Louisiana, which produces a modest amount of oil and hosts many companies that supply drillers in other states, the push to pump more with less is costing jobs, says Ragan Dickens, director of communications for the Louisiana Oil & Gas Association. Much of the talk in the Pelican State centers on “who’s merging next?” and “who’s bankrupting now?” he says.

Wally Drangmeister, director of communications for the New Mexico Oil & Gas Association, echoes those sentiments. The state’s rig count has dropped from 100 to 50 recently, and each of those rigs typically employs about 50 workers. Employees who remain on the job are finding themselves in “spirited negotiations” with drillers over their pay, he says. Odds are, many of the jobs being lost now won’t return, even when oil prices rise. Producers that have figured out how to get by with lower head counts won’t be eager to surrender those cost savings.

The Global Picture

So, what happens to U.S. oil output from here? Odds favor a slight dip, and then a resumption of output growth, as rising production from new wells starts to offset the effect of fewer rigs operating. Demand for refined fuel is strong, meaning drillers will have a market for their crude if they can find a way to pump it profitably.

The U.S. will remain the top producer of petroleum, which includes crude oil and related hydrocarbon liquids such as ethane and butane. Output won’t fall enough to allow number two producer Russia or number three Saudi Arabia to overtake the U.S.

Major oil exporters in the Middle East and elsewhere are in a pickle. Historically, when faced with a major price drop, OPEC would dial back production to tighten the market and put a floor under prices. But now, the cartel seems unable or unwilling to act. To really give prices a lift, the group would have to cut production by about 2 million barrels per day. But cutting back by that much would just open the door to U.S. shale producers, who have shown they can ramp up output very quickly when oil prices are high. Moreover, any OPEC member who honors a production cutback has to worry about its colleagues cheating on the deal to grab market share.

So, despite the low price, expect most major exporters to keep the taps open in a bid to maintain their share of the global oil market and earn what revenue they can. The International Energy Agency expects that global oil output will rise by 1.1 million barrels per day this year, even as prolific shale production in the U.S. starts to falter. That trend should continue, especially with Iran likely to ramp up its output now that U.S. and European governments are preparing to loosen their sanctions on Tehran’s oil exports. Thus, oil will continue to pile up in storage around the world, helping to keep prices in check, much to the chagrin of OPEC and oil exporters everywhere.