US shale oil production could grow by 3.5million b/d to 2022…
Many oil companies around the world have survived the price meltdown by bringing down breakeven costs in the last two years. But what parts of the world can grow output in the years ahead? According to BofA Merrill Lynch, US shale oil producers will come out ahead and deliver outsized market share gains by 2022. Shale oil output in the US may grow sequentially by 600 thousand b/d from 4Q16 to 4Q17 on increased activity in oil rigs and fast productivity gains. Importantly, breakeven costs for key major US plays now stand around the $55/bbl mark. As crude oil prices recover further, cost reflation may partly offset reduced costs linked to less regulation. So assuming a gradual recovery in oil prices into a long-term average of $60 to $70/bbl, we project average annual US shale oil growth of 700 thousand b/d in 2017-22.
…delivering more than 80 per cent of incremental non-OPEC bbls
In addition to US shale, some growth is likely to be seen in Brazil, Russia, Kazakhstan and Canada over the next five years, driven by giant projects in the Lula, Kashagan or Johan Sverdrup fields. However, many of the gains in supply from non-OPEC non-shale producers will come on the back of investments dating to before the collapse in global oil prices.
Meanwhile, countries such as Mexico and the UK will keep facing output declines. All in, non-OPEC output is projected to reach 61.7 million b/d by 2022. This equates to 830 thousand b/d of annual average growth in the next five years, or around the 20-year average of 790 thousand b/d. Put differently, 84 per cent of the incremental non-OPEC supply gains are likely to come from US shale, as production in many parts of the world either stagnates or declines outright.
OPEC faces its long-standing dilemma: volume or price? With non-OPEC poised to grow again, it is estimated that OPEC will need to increase oil output by just 2.2 million b/d to meet global incremental oil demand of about 5.5 million b/d over the 2017-22 period. So about one third of global oil supply growth will come from OPEC in 2017-22.
For now, it is likely that Saudi, Iraq and the UAE are the only countries able to increase their output in the medium term, while Algeria, Nigeria or Venezuela would need massive investments to reverse current trends and boost output. While OPEC countries have the resources to grow production, previous reports show OPEC revenue would likely be higher if no additional investments are made compared to scenarios where increased OPEC production leads to lower prices. For this reason, limited OPEC oil output growth is expected over the next five years.
OPEC market share is now above the 20-year average…
After a 2.5-year battle among the top oil producers, OPEC finally managed to claim back some lost market share from non-OPEC, especially US shale producers. As of 4Q16, OPEC’s market share reached 40.8 per cent, above the 20-year average of 40.3 per cent and 2 per cent higher than in 4Q14 when OPEC reversed its 25-year old policy of managing oil prices. More recently, OPEC agreed to reduce crude production–another major turning point in strategy, at least temporarily. As highlighted in OPEC wants a tripledouble, the cartel’s stated aim is to meaningfully draw down OECD inventories in the short term, which would eventually push the crude oil market into backwardation. In other words, OPEC seems to have regained power over oil prices for now, but the key question remains whether this will hold also in the medium term.
…as the cartel forced one of the biggest non-OPEC cuts in history
By increasing output in a falling oil market, OPEC sped up the collapse in non-cartelized production. Within two years, non-OPEC output went from record growth of 2.4 million b/d p.a. to nearly record annual declines. Last year, Merrill Lynch observed 800 thousand b/d annual decline was almost as large as the one in 1992, when a major exogenous factor, the collapse of the Soviet Union, disrupted oil supplies. This time around, the collapse was driven entirely by the price shock. Producer countries such as the US, China, Mexico and Colombia took the biggest hit. Meanwhile, countries such as Russia and Brazil were more resilient and managed to continue to grow output, helped by falling currencies and massive pre-crisis investments.
Oil companies managed to bring down the cost curve substantially
Over the past couple of years, oil companies have been vocal about reducing costs aggressively throughout all layers of the industry to cope with a “lower for longer oil price environment”. Whether it is due to currency moves or actual cost depreciation, many oil companies around the world have survived the price meltdown by bringing down breakeven costs. Looking at the non-OPEC cost curve by company, modelled by Merrill Lynch’s Oil & Gas equity research colleagues, it was found that the weighted average breakeven cost is now $58/bbl. A similar analysis was done in 2014 and the weighted average stood at $66/bbl. In the US, breakeven costs for most major shale plays now stand below the $55/bbl mark. Unsurprisingly this is the level at which the deferred WTI forward curve has been anchored at for more than eight months.
A small pick-up in global spending can be seen this year and next…
As global balances gradually shifted from surplus into deficit, spot prices rallied nicely last year with Brent bouncing from a low of $28/bbl in January 2016 to $57/bbl last month. This rebound encouraged some producers to return to some fields to drill more wells.
But which parts of the world can grow output in the years ahead? In the US, the oil rig count bottomed in May at 316 and bounced back to 591 last week. Meanwhile, other countries have seen a rather stable rig count for the past three quarters. Of course, the small pick-up in activity expected this year is far from offsetting the 46 per cent drop in global spending in the past two years. It is likely that most of this year’s increase to come from emerging markets and Canadian companies, while US producers seem to maintain spending relatively steadily year-on-year.
…mostly driven by the US where shale output is now rebounding
In the US shale industry maintaining steady spending now seems equivalent to increasing output. In October, Merrill Lynch warned that US shale output was about to reverse its declining trend. Looking at the latest numbers from the EIA Drilling Productivity Report, shale output from the main basins bottomed out in January, and a 40 thousand b/d sequential increase should be seen this month, driven almost entirely by the Permian basin. The recent pick-up in active oil rigs is partly behind the impending rebound in output. Yet, productivity gains are another major factor. The easiest way to measure this on the rig level is by looking at oil production per rig in new wells. Results are astonishing, with steep increases every month in all the major shale basins, although the Permian is starting to look relatively more mature on this measure.
Well productivity gains continue in all basins, even more so in the Permian
This current productivity revolution, if it persists at this rate, will have meaningful and long-lasting consequences for non-OPEC production and thus long-term oil prices. True, part of the gains can be attributed to the collapse of the rig count as only the most efficient rigs remained in place. Yet on the well level, productivity gains have picked up even more in the past couple of years. The six-month cumulative production for an average well has increased by 32 per cent on average across the major basins since 2014. Among major shale plays, the Permian Basin is the rising star, with productivity gains of 64 per cent on the well level. When looking at a well type curve by vintage, we can see that not only have initial production rates kept on surging, but tail production is also getting larger every year.
In the short term, we see a 600k b/d sequential increase from 4Q16 to 4Q17…
Lastly, Merrill Lynch’s colleagues from the US oil service equity research team expect the oil rig count to rise gradually to 667 by 4Q17, averaging 612 this year. Where does all this leave us with US shale production? Taking into account these oil rig assumptions, Merrill Lynch’s 2017 WTI price forecast of $59/bbl, and an uptick in productivity throughout the year, US shale production is set to rebound slightly this quarter and we then expect stronger sequential increases from 2Q17 onwards. Overall, it is likely US shale output will sequentially increase by 600 thousand b/d from 4Q16 to 4Q17. Year-on-year the increase will average 150 thousand b/d. In other words, production should reach 2Q15 highs by the end of this year.
…while in the long run, the annual increase should average 700k b/d at $60 WTI
To estimate US shale production growth over the next five years, a price sensitivity analysis was conducted based on break-evens, drilling potential, annual decline rates and productivity gains. Merrill Lynch estimated that US shale production will decline annually by 270 thousand b/d, on average, until 2022 in a $40/bbl WTI environment. At $50/bbl, growth returns, though only at a small average of 240 thousand b/d. Should WTI trade at $60 for the next five years, growth reaches 700 thousand b/d, and at $70/bbl it reaches 950 thousand b/d. It goes without saying that the level of US shale output in 2022 will highly depend on the average price of WTI in the next five years.
Costs are likely to pick up, partly offset by less regulation
US shale oil producers are likely to come out ahead and deliver outsized market share gains by 2022. Assuming a gradual recovery in oil to a long-term average of $60 to $70/bbl, average annual US shale oil growth of 700 thousand b/d in 2017-22 is projected. As crude oil prices recover, cost reflation is likely across the sector, whether from service companies or producers themselves.
Rig day rates started to pick up last December by one per cent MoM and latest data show a three per cent monthly increase in January. According to our US oil service equity research colleagues, the mix between spot and term contracts to hire rigs has improved, with long-term contracts representing 20 per cent of total work in January, well above the 10-11 per cent in August-November.
This suggests US oil producers are anticipating cost hikes in the next six to 12 months. On the other hand, a more pragmatic approach to regulation from the new administration is also expected. This may reduce the costs associated with regulation and improve profitability, partly offsetting the uptick from cost inflation.
The relentless non-OPEC growth from 2018 onwards can now be seen…
All in, non-OPEC output is expected to reach 61.7 million b/d by 2022, cumulative growth of 4.1 million b/d from 2017 levels. This upward revision from last year’s medium-term outlook is driven mainly by higher output in US shale and Russia.
Last year, Merrill Lynch expected 2017-20 growth of 1.7 million b/d for US liquids output. Given the resilience of US shale output throughout the downturn, the current recovery in rig count, and productivity gains in the past 12 months, US liquids output is now expected to grow by 2.1 million b/d in that period.
As for Russia, a decline of 370 thousand b/d from 2017 to 2020 was initially expected, but now a reversal in this trend to growth of 320 thousand b/d is more likely. Total non-OPEC output should then expand by 830 thousand b/d on average in the next five years, around the 20-year average of 790 thousand b/d.
…mostly driven by shale and major projects at the end of the decade
For this year, annual non-OPEC output growth is set to resume no later than 2Q17, mainly driven by Canada, following giant disruptions in May and June last year. Later this year, US should be back to annual growth with both Gulf of Mexico offshore and onshore shale posting enough drilling activity to offset declines from mature fields. Looking forward, non-OPEC growth should be driven by the US, albeit at lower levels than in 2012-15, and other major projects such as Lula, Kashagan and eventually Johan Sverdrup in Brazil, Kazakhstan and Norway, respectively.
Technology and costs will set the long-term price equilibrium
Beyond these major projects, where investments were made in the $100+/bbl oil price environment, a lot of smaller projects have been postponed or cancelled in the past two years as they suffered from unaffordable breakeven prices. Yet producers around the world have gradually managed to bring down breakevens for a lot of projects, bringing the whole cost curve down and the long-term crude oil prices along with them.
Since January 2015, the December 2020 Brent crude oil contract followed an almost-straight line down from $80/bbl to $55/bbl, while spot prices are currently trading at the same levels as two years ago. Long-term prices have been relatively stable at these levels for the past nine months, suggesting that the price cycle has potentially hit the bottom. Merrill Lynch’s Oil & Gas equity research colleagues in Asia expect Chinese oil breakeven costs to rise again this year and thereafter. Whether it is in China, the US or everywhere else, the oil industry is likely about to experience cost reflation and the magnitude is likely to be set by technology.
OPEC is likely to capture about one-third of the incremental barrels
In sum, the US is likely to account for 80 per cent of total non-OPEC growth in the next five years. Given Merrill Lynch’s medium-term outlook of $70/bbl Brent, non-OPEC producers will probably provide four million b/d of incremental barrels between 2017 and 2022. With non-OPEC poised to grow again, we estimate OPEC will need to increase oil output by just 2.2 million b/d to meet the global incremental demand of 5.5 million b/d over that period.
About one third of global oil supply growth will come from OPEC in 2017-22. In this base-case scenario, the market is likely to gradually move from a deficit in 2017 to balance by 2021 and 2022. For now, Saudi, Iran, Iraq and UAE are the only countries able to increase their output meaningfully in the medium term, while countries such as Algeria, Nigeria or Venezuela would need massive investments to reverse current trends and boost output.
In the long run, Saudi is better off capping output and allowing prices to rise
As highlighted in a recent note, from a pure economic standpoint, Saudi would likely be better off maintaining steady production and allowing prices to rise to maximise their long-term oil revenue. Saudi Arabia needs a certain combination of price and quantity when it comes to oil to meet budgetary requirements and higher output should bring more revenues. Yet, over a 15-year period, Saudi total oil revenues at $50/bbl and 18million b/d of production would equate to $4.90trillion. Meanwhile, a combination of $65/bbl and 12 million b/d production would bring in $4.30trillion. Yet, given production costs of $10-to-$20/bbl, it simply would not pay off for Saudi to aggressively invest in domestic oil productive capacity, even if assuming a zero discount rate on incremental future revenues.
It makes little sense for OPEC to increase oil investments
Should OPEC opt to invest to increase production aggressively to meet 100 per cent of demand growth, prices would likely remain stuck at $50/bbl in the long run. But why would OPEC not opt instead to meet just one third of future oil demand growth and capture a higher price?
The trade-off seems pretty straightforward. In most scenarios, OPEC revenue would likely be higher if no additional investments were made, compared to scenarios where investments translate into increased production capacity and, hence, lower prices. For this reason, we expect limited OPEC oil output growth over the next five years.