WTI is back in the upper-$50s per barrel, and OPEC is on the verge of extending its production limits well into next year. The fear for OPEC, and other oil bulls, is that this risks sparking another wave of U.S. shale supply, sending oil prices right back down to where they came from. But what if U.S. shale fails to keep up with soaring demand?
That’s the conclusion from Morgan Stanley—a prediction that flies in the face of conventional wisdom. When OPEC signed its deal a year ago to limit production, oil prices moved up into the $50s per barrel, and over the next 12 months, the U.S. brought about 1 million barrels per day (mb/d) back online. With crude prices back at similar heights, shouldn’t another dose of shale production be a sure thing?
Morgan Stanley says that while U.S. shale drillers could add new production, they won’t be able to keep up with market demand. The investment bank says that the shale sector will have to grow production from about 5.9 mb/d this year to over 7 mb/d in 2018 in order to ensure that the market doesn’t plunge into a deficit, a level that the industry is unlikely to achieve. Shale drillers have proven that they can add that amount of supply in a short period of time in the past, but further gains will be much harder to achieve.
“Right when the world’s reliance on shale is growing, its limits are starting to become apparent, and there seem to be two aspects to this: ability and willingness,” Morgan Stanley analysts wrote last week.
The shale sector has run into a range of obstacles in recent months. Higher drilling costs and a shortage of fracking crews have led to bottlenecks. Oilfield services companies are demanding higher prices from producers. Also, there have been operational problems—some shale wells are producing more gas than expected, a bad sign for wells assumed to produce heavier volumes of oil.
A range of other metrics point to sudden struggles for shale drillers. Improvements in drilling times have also stagnated over the past year, indicating a limit to the “efficiency gains” that can be achieved by drillers. Rig productivity, as measured in initial output from new wells per rig, have been falling since 2016. Meanwhile, perhaps the most important metric of all—profits—continues to disappoint.
The latest roadblock for the shale industry comes from their restive shareholders, who are demanding a strategy overhaul after years of broken promises and red ink. Investors are pushing for spending cuts, changes to executive compensation and more cash returned in the form of share buybacks. The aim is to focus on profits, not production growth.
Shale’s struggles come at a time when demand looks solid. The IEA sees demand growing at a 1.6 mb/d annual pace in 2017, a fairly robust figure.
If the baseline assumption that U.S. shale will come roaring back immediately after OPEC extends its cuts is not based in reality, then OPEC might actually have a lot more room to boost prices. Keeping 1.2 mb/d (plus nearly 0.6 mb/d from non-OPEC countries) offline for another year could push the market into a deficit situation, leading to accelerated inventory drawdowns and higher prices.
Still, OPEC isn’t taking the hiccups in the shale sector for granted. The cartel just boosted its assumption for production growth coming from the U.S., acknowledging that the Middle East will face stiff competition for market share for years to come.
But Morgan Stanley says U.S. shale has used up a lot of its firepower already. Boosting shale output to 7 mb/d by next year would require shale drillers adding something like 8 to 10 new oil rigs each month. The rig count has fallen steadily since June, and would need to climb substantially to continue to raise production.