The Organisation of the Petroleum Exporting Countries (OPEC) attempted to address the issue of global oversupply at the end of 2016 by introducing a cap on production. However, since the cap came into force at the start of 2017, crude oil prices have actually fallen around 15%.
There have been signs of growing discontent between members towards the production cap. Compliance to the deal fell to just 78% in June, the lowest rate so far. Global oil output rose by 720,000 barrels a day last month, as even countries subject to the deal, including Saudi Arabia, raised output. Libya and Nigeria, exempt from the cap, have also been raising production levels. Ecuador became the first country to publically announce it will defy the production cap. Its Government made clear it needs to raise revenue to tackle a financial deficit.
Following these developments an extraordinary general meeting was held between OPEC members and others party to the deal, as the organisation attempted to maintain control of its members output. Nigeria is now expected to join the cap once its output stabilises at 1.8 million barrels per day. However, it is developments in the United States which should be of greatest concern to OPEC’s power struggle; not only rising production levels but a transformation in oil drilling.
Throughout 2017 the action from OPEC has been undermined by growth in US production, which increased by more than 500,000 barrels a day since the OPEC cap was introduced. The US is outside of the OPEC deal, and has been eating into OPEC’s global market share this decade. Some have pointed to the US Rig Count – an established measure for US production – as a sign that output from America could be on the verge of falling. This may not be the case though, due to an evolution in oil project development.
The US Rig Count measures new oil and gas drilling activity and is often used as a proxy for US production. However the Count’s relationship with output and price appears to have altered in the last year.
During 2015, the US Rig Count fell by 60% from 1,800 rigs in January to 698 by December. This corresponded with a sharp fall in the oil price during the second half of 2014. As the wholesale price of oil fell, so did the investment signal for new oil production. The average West Texas Intermediate (WTI) oil price for the US dropped from $100/barrel in August 2014 to under $50/barrel by March 2015. With less revenue from the oil, wells were left incomplete, rigs were shut down and new projects were shelved.
However, this has not been the case in the last year. US crude prices have fallen from $55/barrel to $45/barrel since the start of the year. US production has also risen by 6% in the same period.
Drilled but Uncompleted Wells (DUCs)
While some of the increase could be linked to a rise in the Rig Count – which has increased despite the lower wholesale price – the major reason behind this change has been a significant increase in Drilled but Uncompleted Wells (DUCs). These are wells drilled but not completed to the point when oil could be extracted. In order to complete a well and begin oil extraction, shale producers blast sand, water and chemicals into the drilled well at high pressure to generate rock fractures and release the oil.
The growth in DUCs can be traced back to the start of 2016. WTI oil prices doubled from $27 to over $50/barrel in the first half of 2016. As the price recovered, operators were expected to extract the oil from previously drilled wells before then spending money on drilling new ones. Instead, new drilling activity expanded and the number of DUCs rose sharply. In the Permian Basin, one of the largest drilling sites in the US, DUCs rose 47% between March 2016 and March 2017 to a new record high. The US Energy Information Administration (EIA) began publishing DUC data in September 2016, amid growing indications that the DUC data provided a clearer estimate as to the extent of US oil production.
Furthermore, production from each rig is rising as more wells are being drilled off each rig. As the industry moves further towards larger and larger sites, the Rig Count is rising and so is the number of incomplete wells. As the number of wells for each rig increases, overall US oil production can rise – as it has done in 2017 – despite the Rig Count remaining below 1,000, close to half the peak level seen just three years ago.
Why do DUCs matter to oil prices?
A rise in DUCs indicates there is a large number of wells which can be completed in a short period of time. This means DUCs can respond very quickly to any rise in oil prices. Furthermore, oil can be extracted from DUCs at much lower cost than drilling a new well. The effect of a potentially high volume of US oil coming online in a short period of time makes it even more difficult for the global oil market to rebalance at current price levels. OPEC’s production cap has been undercut by rising US production during 2017. However, the rise in DUCs shows there are even greater volumes of untapped supply, ready to flood the market at short notice and low cost to the operator.
OPEC attempted to flood the oil market itself in 2015, lowering prices to curb the threat of US shale production. However, this may have backfired, encouraging the evolution in drilling techniques. Now, OPEC has reduced its production as part of a plan to raise prices, but the changing drilling patterns in the US have led to a steady increase in overall US production. As a result, we have seen oil prices capped, and even falling, since OPEC’s production cuts came into force this year, with US activity determining the market balance, not OPEC.
This raises the question of what OPEC can do – if anything – to re-establish a dominance in world oil production, and whether the DUC count is the new indicator for US oil supplies.