With the U.S. now the de facto swing producer for the global oil industry, a key factor in understanding when oil markets might rebalance is how much U.S. production could ultimately fall from recent record highs.
Positively, U.S. supply resilience in the face of falling investment is turning out to be a temporary phenomenon. Production has in fact already started to fall, and since the March peak of 9.7mmb/d, crude oil output is down 5%. Consensus points toward U.S. oil production falling further in the coming months, but also appears to indicate that there will be resilience in 2016.
Price volatility will remain higher going forward
As discussed below, we disagree with the latter notion and believe next year's declines are likely to be substantial. This is the case even after considering production tailwinds such as continued efficiency gains and inventory high-grading, as well the assumption that a sizable portion of the uncompleted well inventory is brought online next year.
Based on our projections of a horizontal rig count of 500-500 in the tight oil plays (the industry has been running between 540-560 during the past three months), we expect U.S. oil production to fall by 600-800mb/d during 2016, with monthly volumes bottoming around 8.2mmb/d later next year. This is a bearish outlook relative to consensus, with the variance explained by the fact many forecasters continue to hedge their bets on what 2016 activity levels will be.
Morningstar's projections assume U.S. rig counts will fall in the final months of 2015 and then stay at trough levels until the second half of next year. Such activity levels are simply too low to offset the high decline rates of tight oil production. If our expectations are correct that drilling does not pick up in the next few quarters, we'd expect industrywide production forecasts to be revised downwards just as they have during the last few months.
Further, onshore production outside of tight oil plays, for example, conventional fields, stripper wells, and California heavy oil, is also declining from a lack of investment and has fallen roughly 200mb/d in the last six months. We expect a further 200mb/d of declines from these areas through 2016.
Indeed, if it weren't for the resilience of the Permian, U.S. oil output would experience even more pronounced declines. Taken alone, production declines won't fix the industry's supply/demand imbalance, but they do inform our expectation that the industry can rebalance and heal itself during the next two years.
Of course, activity levels in the tight oil plays could be higher or lower than we're forecasting. As a general rule of thumb, each 100 horizontal rigs active in the tight oil plays during 2016 equates to roughly 275-350mb/d of 2H 2016 production.
Steep near-term U.S. production declines are clearly a positive for oversupplied crude markets that desperately need be rebalanced. But declines stemming from a lack of investment should not be mistaken for any change in the long-term potential of U.S. oil production. Tight oil remains the key source of midterm global supply growth, and can easily produce at volumes well beyond the peak levels it had reached earlier this year when investment recovers. Given our bullish outlook for WTI, recovering to $60-$70 per barrel by 2018, we expect the current period of low rig activity will be temporary.
However, these same tight oil qualities, strong economics and robust growth potential, should also temper long-term oil price expectations: any period of prices above our long-term price outlook would lead to aggressive drilling and production growth that would lead to excess supply. While fundamentals will improve from here, this tightrope dynamic implies oil price volatility will remain higher going forward than it was during the period of persistently high prices that predated the current downturn.
