The end of the oil glut

In my last post, I talked about how America had depressed oil prices by increasing its supply. Recall this graph which shows that the supply glut is primarily caused by increased American supply (the top pink line is America):

The glut is mostly due to America producing more oil

The glut is mostly due to America producing more oil

Since low prices are mainly caused by American oversupply, a decrease in American supply will have a major impact on prices. And it does look like American supply might wind down. The next graph shows how American oil production responds (eventually) to the number of oil rigs in America.

Just to clarify, “rigs” here refers to rotary rigs – the machines that drill for new oil wells. The actual extraction is done by wells, not rigs. But American oil supply shows a remarkable (lagged) covariance with rig count. From the 1990 to 2000, the number of rigs decreased, and oil supply followed it down. Then, when the number of rigs jumped in 2007, oil supply also rose with it.

Note that the number of American rigs has plummeted since the start of 2015. It is no coincidence that oil prices hit a record low in January 2015. At these paltry prices, oil companies have less of an impetus to dig for more oil.

The number of oil rings in America has halved since January 2015

The number of oil rings in America has halved since January 2015

The break-even price for shale oil varies according to the basin (reservoir) it comes from. A barrel from Bakken-Parshall-Sanish (proven reserves: 1 billion barrels) costs $60, while a barrel from Utica-Condensate (4.5 billion barrels) costs $95. The reserve-weighted average price is $76.50. These figures were calculated by Wood McKenzie, an oil consulting firm, and can be viewed in detail here.

As the number of rigs has halved to 800, the United States will not be able to keep up its record supply. Keep in mind that wells are running dry all the time, so less rigging will eventually mean less oil. Perhaps finally, the glut is about to end, with consequences for oil prices. To put things in perspective, the last time America had only 800 rigs (end January 2011), oil was at $97 a barrel.

Oil probably will not return to $100 a barrel. If it does, shale oil will become profitable again (the threshold is $76), American rigs will come online again, supply will increase and prices will come down again. So oil will have to find a new equilibrium price to be stable. A reasonable level to expect for this equilibrium is around $70, the break-even price for shale.

There will probably be a lag in the reduction of American supply: Note how oil supply does not immediately respond to the number of rigs. But things move faster when expectations are at play. On the 6th of April, traders realized Iranian rigs were not going to come online as fast as they thought. Oil prices rose 5% in one night. American supply does not have to come down for prices to drop: traders simply have to realize prices will come down.

Data from US Energy Information Agency and Baker Hughes, an oil rig services provider. Graphs plotted on R.

Abbas Keshvani