OPEC gets to eat the Permian’s lunch
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In any commodity market, the marginal supplier makes hay when the sun shines. Oil prices are rampant, but tight oil is not behaving quite as expected. I caught up with R.T. Dukes, Head of US Lower 48 oil supply.
So R.T., tight oil production is surging on higher oil prices?
Yes, but from the jump in prices in 2016/17. Volumes are currently 5 million b/d – that’s up 1.6 million b/d in 24 months. The growth is mainly from the Permian, which is now producing just over 3.2 million b/d in total. Two million b/d of that is tight oil, which has doubled from the lows.
The growth has come faster than we expected because of the rapid rate of investment. The horizontal rig count targeting tight oil jumped from ~250 in May 2016 to 622 by the end of 2017, and we are seeing the production flowing from these wells coming through this year. But we expect activity to tail off in 2018.
The oil market’s marginal producer slows with prices rising?
It’s counterintuitive, but there are good reasons. The Permian is still the prize basin containing the majority of the low-breakeven tight oil plays and biggest sweet spots. The outlook for medium-term growth is very promising, and we expect the Permian will be the engine that drives the doubling of tight oil volumes to 10 million b/d by the mid-2020s.
But short-term, there are physical constraints – there’s only 3.4 million b/d of pipeline capacity.
In addition to tight oil, the Permian has just over 1 million b/d of legacy production from vertical wells.
The combined volumes mean that the infrastructure is crammed full – there’s little or no room for incremental volumes.
What’s the economic impact on operators?
Those who have purchased pipeline capacity can shift their production, but it’s an expensive problem for those without. WTI at Midland is trading US$10/bbl below the price at the coast, the spread reflecting the cost of trucking or railing crude to market. A lot of new wells could still make money at US$60/bbl, but there’s a disincentive to invest. There are around 670 horizontal oil rigs working in May 2018, and that’s likely the peak. Operators won’t drill if there’s no room to take away additional production.
This must be frustrating for shareholders?
Actually, it’s the opposite. Yes, the lack of pipeline capacity is holding back growth. At the same time, tight oil has seemed a bottomless pit for investment, and investors have made it clear they want a return on their capital.
In the short term, it’s as if all their Christmases have come at once – higher production, higher prices, lower investment.
This year, Tight Oil Inc. will make money, generating free cash flow two years earlier than we expected. Much of that will be returned to shareholders.
What are the prospects for new Permian pipe capacity?
Slower than ideal. Around 0.3 million b/d is due to come on by end January 2019, but it's really from next summer that we’ll see big new capacity. Between June and December 2019, another 1.25 million b/d will be built out, lifting total capacity up to 5 million b/d – that’s when the big discount of WTI at Midland will narrow.
By then, we forecast total Permian volumes at about 4 million b/d, with tight oil up to 3 million b/d. We think there will be three to four years of running room before the pipes fill up again. Some operators, though, are more bullish and reckon operators will respond with more volumes – ‘build it and they will come’.
This sounds like good news for OPEC?
It is, in the short run. The Permian’s added 1 million b/d to global supply in the last year, and would do at least the same again over the next at today’s oil price, without constraints. But growth will be limited to around half that. Tight oil’s been eating OPEC’s lunch for the last few years. The lack of infrastructure will temporarily cede market share back to OPEC.