thinking about the oil price

I’ve been reading lately that many US oil companies are continuing to drill for shale oil, despite the fall in the price of crude.  However, while they are finishing drilling holes in the ground, they’re not yet “completing” the wells.  That is, they’re not fracking the underground deposits by pumping in water/sand/chemicals to create a path for the hydrocarbons to get to the well.  Nor are they installing the equipment a working well requires.

There’s even a name for these already drilled but not completed wells–fracklog.

The decision not to complete is easy to understand.  There’s already too much oil sloshing around in the world.  Why spend money to add to the problem–maybe even pushing prices down enough to make your own efforts unprofitable.

Why continue to drill, though?

Lots of potential reasons.

A drilling rig may be under contract, so the oil explorer has to pay for it whether used or not.  Drilling a certain number of wells may be necessary to keep mineral rights to specific acreage.  In the case of companies with too much debt, the bankers may be calling the shots (although such wells will surely be completed as fast as possible).  Some exploration firms have also made it clear that they consider today’s oil price to be a purely temporary dip.  So they’re going to continue to drill no matter what.

What’s important for investors, though, is how the fracklog may affect any rebound in the oil price.

My picture is that oil is bouncing along at or near the bottom, waiting for high cost production to leave the market.  As/when that happens, and as world GDP growth gradually increases demand for petroleum, the oil price will begin to rise again.

I think the fracklog creates a ceiling above which oil will find it difficult to rise.  It implies that when these backlogged wells become profitable enough, a rush of new output will hit the market.  Maybe the appropriate price is $70 a barrel.  $60, anyone?  It’s almost certainly below $100.

If I’m correct, an eventual oil price rise will be unpleasant for consumers but not devastating.  Also, the buy/sell decision for any oil producer becomes much more a sharp pencil exercise than a thematic call on the possibility of boundless price increases for output.

 

 

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