US gas May15
Simple stories aren’t always true.  That’s certainly the case with the fiction that the fall in the number of US oil drilling rigs will soon reduce US oil production.

Exxon Mobil CEO Rex Tillerson recently reminded us of this critical point:

Clearly a significant decline in rig activity did not diminish the continued growth of natural gas capacity even in a very difficult price environment. Is that analogous to the tight oil? I think that’s what we’re all going to learn.”

Latest data from the US Energy Information Agency confirms his comment, as the chart above shows from the vast Marcellus gas field:

  • The number of drilling rigs has almost halved since 2012 to around 80 rigs today (black line)
  • Over the same period, actual gas production has nearly trebled to 8.1 tcf/day (blue)

This, of course, is the long-term history of oil and gas production since oil was discovered 150 years ago.  Periodically, prices move higher, encouraging capacity expansions – and luring in investors who believe they see an opportunity to earn risk-free profits.  But then the new production comes online, flooding the market, and prices collapse again.

We have seen this cycle in action for US natural gas prices over the past few years:

  • Lack of drilling activity and Hurricane Katrina caused prices to temporarily spike above $13/MMBtu in 2005
  • They then had another jump back to $13/MMBtu in mid-2008, as oil rushed to its $147/bbl peak
  • This convinced investors that prices could “never” fall below $8/MMBtu or, at “worst” $6/MMBtu
  • Since then, the only direction has been down: gas production has climbed every year since 2011, causing prices to fall today close to $2/MMBtu

And all the time, of course, technological improvement and cost-cutting is further pressuring prices.  Current breakeven production prices in parts of the Marcellus field are just $0.38c/MMBtu.  Producers in nearly Utica field can even sell at a cash-loss, because of demand for ethane and other natural gas liquids.

Of course, there are powerful forces in the oil trading market that can always take prices higher temporarily.  But their actions are eventually self-defeating:

  • Today’s higher prices are giving US and other producers the opportunity to hedge their H2 output at highly profitable prices on a cash-cost basis
  • At the same time, producers are busy cutting costs as fast as they can – following the example of their colleagues in gas production

In addition, and sometimes forgotten in the shale bubble drama, the US actually has 3-way competition in its energy markets.  Coal is also a major supplier.  And so natural gas prices need to remain below $3/MMBtu in order to compete with coal supplies.

In turn, therefore, oil prices will soon probably need to trade around their relative energy value to gas, currently $20/bbl, if all the new oil output is to find a home.