US shale – Dark at the end of the tunnel
Rocketing rig counts mean US production could surprise to the upside, with record shale production levels likely by 2018. This could threaten the anticipated crude market rebalancing and has been a major factor behind our negative view on oil prices since late 2016.
As outlined in our earlier post Oh Heck, OPEC, we're sceptical about OPEC and Russia's commitment to production cuts, but still think that a production fall of 0.7 million barrels a day is likely as a result of their meeting. We took a negative view on oil prices, worried that investors were over-optimistic and ignoring the downside risks. A dramatic rebound in rig counts now makes US shale a clear and present danger to oil prices.
Despite the value of the US dollar falling (which tends to push up oil prices), oil prices have gone sideways since the start of the year and are below those implied by the forward curve at that time. The rebound in US shale is a key reason why, with rig counts up nearly 15% in the first seven weeks of the year to about 600.
We'd expected rig counts to increase to around that level by the middle of the year, so the actual outcome is a material surprise to the upside for oil production. While US shale only represents about 6% of global oil production, its ability to ramp up quickly makes it a wildcard for 2017.
Rig counts are a key driver of US shale production, along with productivity improvements that come from technological progress. Productivity improvements are set to slow from 2015-2016 levels in the US, as one of the big gains has been reducing the time taken to drill each well and there is a limit to how far that can fall. Therefore we generally assume productivity improvements in line with the average of the last five years.
Increasing our expected rig count to 650 from 600 for the end of 2017, we now expect 200,000 more barrels per day in production by the end of the year than we did previously. This counteracts about a third of our anticipated OPEC and Russia production cuts.
As investors digest the news, it is causing them to question how likely it is that the market moves into deficit in 2017, as had previously been assumed. We now expect rig count growth to slow, but to reach over 700 by end 2018, assuming the oil price moves in line with current market expectations. We think this would lead to a new peak in US shale production of around 7 million barrels a day.
If this scenario plays out, then the tunnel to oil market rebalancing will get a lot longer and darker than markets currently expect, once again testing OPEC's commitment to supporting prices. The next big test for OPEC will be how they react to this latest setback and whether Saudi Arabia makes good on its promise to cut production more if required. If not, then a return to oil prices below $45 could loom large on the horizon...