Publications: Notes at the Margin

US Future Crude Production: An Inconvenient Development (March 11, 2019)

 

The US Energy Information Administration and most other forecasting organizations optimistically predict increases in US oil production for as far as the eye can see. The February Short-Term Energy Outlook issued by the EIA, for example, sees US crude output rising from 11.9 to 13.5 million barrels per day between the end of 2018 and the end of 2021. The International Energy Agency will likely echo the EIA forecast when it releases its five-year projection this coming week.

 

Exxon and Chevron announcing their intention to intensify activity in the Permian Basin last week will embolden forecasters to see even larger increases in domestic output. Between them, the two companies look to boost production in the Texas/New Mexico area as much as one million barrels per day in four to five years.

 

The projections for US production growth, combined with concerns regarding the global economy’s slowing growth, have contributed to the pessimism that pervades the global oil market. Energy equities have become unpopular and oil price forecasters generally gloomy.

 

In the short term, this pessimism may be well placed. There might, though, be a surprise over the horizon. US production might decline instead of increasing as projected by the EIA. The peak, if it comes, could happen around January 2020. By the end of that year, US crude output could be two million barrels per day below projected levels.

 

We base this projection of possible decline on shrinking futures market activity. Over the past ten years, the movement of various indicators derived from the futures market has been an excellent predictor of future oil production. This type of prognostication works because so many of the smaller firms responsible for greater production from the five major fracking provinces in the US (the Bakken, Eagle Ford, Haynesville, Julesburg, and Permian basins) have relied on significant borrowing to move forward. As often noted here, investors have been highly critical of these firms for failing to make any money in the process.

 

To assure their survival, many of these firms have also hedged a substantial portion of their future production. As new wells are developed and production profiles computed, the companies enter into some type of swap or collar (buying a put and selling a call) to ensure their future cash flow.

 

We modeled the relationship between Lower-48 production and open interest. While far from perfect, the relationship is relatively close. We then compared the EIA’s forecast of Lower-48 production with the projection generated from our analysis. The difference by the end of 2020 is 1.8 million barrels per day. The implication is that the reduction in hedging warns of a very sharp decline in US oil production.

 

The largest impact from the cut in US oil firms’ investment and output comes not in 2019 but in 2020. The shortfall in US production allows oil exporters to boost their volumes by almost ten million barrels per day, assuming they accept prices close to today’s levels.

 

As an alternative, oil-exporting countries may elect to maintain their output levels and allow prices to rise. Global inventories would decline under such circumstances. A simulation with the PKVerleger LLC “but-for” model shows that Brent crude prices would end 2020 at $92 per barrel instead of $82 should OPEC production follow the EIA’s projection trend.

 

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