Comments: A New Swing Producer
Authors: Donnelly John 
Published: February 2016

Editor's column

OPEC’s decision last year not to cut production in order to defend market share and drive some high-cost producers out of the market appears to be working. But it is setting up a new market paradigm, argues a new study, which could have long-term implications for the oil industry.

Bellwether industry data show sharp drops in drilling and in the rig count in the United States since prices began to fall last year. The price of benchmark oil had fallen by 60% by the end of January before starting to rise in February. And the Baker Hughes Rig Count in early February showed a decline of 553 rigs, or 34%, since early October, the steepest drop since 1986. That will slow production growth this month in four of the most prolific unconventional plays in the US—Eagle Ford, Permian Basin, Bakken, and Niobrara, according to the US Energy Information Administration (EIA). It expects total production from these four to increase by 63,000 B/D in March, 40% less than previously expected growth of 103,000 B/D. The EIA is still predicting a rise in overall US oil production this year but a decline in production growth.

A study issued in February by Rice University’s Center for Energy Studies says the drop in new US production is coming almost exclusively from high-cost shale plays, with conventional oil production largely unaffected. The biggest decline has come from New Mexico and the Permian Basin. “The shale industry is now revealing itself as a nimble and price responsive producer at a time when OPEC member states have refused to squelch their own production, thereby rejecting their customary market balance role,” says the report, titled Effects of Low Oil Prices on US Shale Production: OPEC Calls the Tune and Shale Swings. The “swing producer” role traditionally has been played by Saudi Arabia, as its enormous spare capacity allowed it to add or curb production to influence global prices. Before OPEC, the Texas Railroad Commission tried to enforce production quotas to encourage price stability.

This is a snapshot of how the industry is adjusting to its new economic environment. The shale industry may be an ideal swing producer because of its high cost, short lead time for investment, low barriers to entry and exit, steep decline curves, and requirements for continuous drilling to maintain output, argues the report. “What emerges is an illustration of the diverging fortunes of an industry that appears to be shifting into a low-price mode in which retrenching firms set aside drilling plans in less productive zones and focus efforts on their most productive acreage and highest efficiency extraction techniques,” the report says. That “portends a new paradigm in an industry where decades-long investment horizons have typically led to over- or under-shooting market needs, contributing to price volatility.”

The unique characteristics of shale, such as its price responsiveness, allow it to act almost as a manufacturing process compared with conventional oil and gas exploration and production. Shale does not perfectly fit the swing producer role because US crude primarily serves a domestic and not an international market. But the shift may bode well for the industry as a whole. The nimbleness of shale producers to quickly enter and exit the market may give global markets useful spare capacity to modify supply/demand imbalances, which will help conventional projects that have long lead times from investment to first production. JPT