The Fundamental Asymmetry
Why this oil price band will eventually sow the seeds for an oil price spike.
US oil production has been the key supply growth engine for the global oil market over the last decade. Namely, the Permian has been the sole growth engine that has kept the global oil markets from a structural supply deficit. Without the rise of the Permian in 2016, global crude oil supplies would have been lower by ~4 million b/d, and if you include NGLs, that figure gets close to ~7 million b/d.
In terms of global oil market balances, this is not a figure to sneeze at. Accounting for ~7% of global oil supplies today, the Permian should really be renamed the savior of the structural supply deficit.
But we are now entering an important inflection period in the global oil markets. Permian is maturing with producers focused on asset longevity as opposed to growth. With Diamondback Energy acquiring Double Eagle, the last meaningful private producer in the Permian, the consolidation phase is coming to an end.
With Permian crude production set to slow materially, an interesting dynamic is starting to happen in the oil market. While we are contrarians at heart, we have a lot of respect for the market, and the market is extremely intelligent today to price WTI right at the Goldilocks range.
What do you mean?
I firmly believe that $65-$75/bbl WTI is the worst-case scenario for US shale oil producers.
Why?
The returns from drilling are adequate enough to where each producer is incentivized to keep production flat, but the prices aren't high enough to justify drilling tier 2 or 3 wells.
This results in top-tier wells getting depleted just to keep production flat, which is not the best-case scenario if you are an oil producer.
But as a producer, you also cannot justify lowering production because you have to meet dividend and share buyback requirements. And with regards to the decline profile of shale production, it's much easier to keep production flat vs letting it decline and then growing it back up.
The market, as a result, is keeping prices just high enough to where no material supply loss takes place, but not high enough to where producers can use tier 2 and 3 wells to replace the declining production creating a perfectly bad scenario.
For most shale executives, they will say to investors that prices are adequate enough to justify the return to shareholders, but let's face it, drilling your top wells at $70/bbl is not the outcome anyone wishes for. For obvious reasons, you want to drill the crappier wells when oil prices are low and save the best ones for when prices are higher.
But that's the nature of the E&P business and I suspect investors are going to be surprised the next time oil prices rally, US shale producers lag the production increase needed.