The looming threat to American oil output

Drilling rig count in focus
Drilling rig count in focus

In recent weeks, the market has shifted its attention from cratering crude prices to the falling number of rigs operating in American oilfields. But in the coming months, the very life cycle of many of those wells may have many market watchers concerned about output and price stability, experts told CNBC.

Oil wells—whether conventional or unconventional—reach peak production soon after they yield the first drop of crude. The difference is how quickly they enter decline.

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Conventional wells go through a long period of steady, flat production between peak and decline. In contrast, production falls rapidly in the first three years of unconventional wells—those in shale, sandstone and carbonates. They then enter a long phase of very low production.

In order to even keep production steady across an unconventional oilfield, producers must constantly drill new, high-producing wells. Now they're cutting back on exploration, and many investors and energy companies do not fully appreciate how many new wells producers will have to drill in order to get production back to where they were, said Michael Rowe, vice president of exploration and production research at Tudor Pickering Holt.

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On Tuesday, the International Energy Agency projected that oil supplies will continue to increase throughout this year. But in fact, oil supplies and prices may be much more volatile over the coming couple years, said Murray Olson, a former geological engineer and co-founder of Calgary-based Northern Blizzard Resources.

"These rapid changes in the price of oil will be a feast-and-famine set of economic consequences for the next few years, with much instability," Olson said.

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For the last nine years, American oil production has only climbed, growing steadily from 5 million barrels per day in 2005 to 8.6 million last year.

Drillers in the top seven U.S. shale plays get 43 to 64 percent of the oil out of their wells in the first three years of pumping, according to research by David Hughes, a fellow at the Post Carbon Institute. In reports published in 2013 and 2014, Hughes has said that the U.S. Energy Information Administration's long-term oil output projections are overly optimistic.

The problem at present is that so-called "tight oil" drillers are cutting capital expenditure budgets, and creating new wells is a front-loaded investment. Nearly all of the costs come in the first two phases: drilling for exploration and hydrofracking, the process of pumping a mixture of water and chemicals into the ground to break up rock formations and release oil and gas.

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The number of rigs drilling new oil and gas wells in the United States has fallen 25 percent from the highs in September. The slide has accelerated in the last two weeks, with another 177 rig reductions, bringing the total number of operating rigs to 1,456.

To be sure, some new wells have been drilled, but producers have delayed fracking them. In its most recent report, the North Dakota Industrial Commission pointed out that 775 drilled wells in the state's Bakken Shale were waiting to be completed at the end of November. While some of the wells were not being completed due to a backlog of work for fracking crews, some companies have made the strategic decision to put off the investment in the second phase, Hughes told CNBC.

Will the oil and gas cost cuts be permanent?
Will the oil and gas cost cuts be permanent?

However, they've already drilled many of the most economic wells. Currently, exploration and production companies are "high-grading," or moving rigs from marginal parts of their portfolios to areas with more economical wells.

In the medium term, they will have to start drilling the less economical wells, Hughes said. That means their break-even prices will only get higher over time.

"The wells don't get any cheaper when you drill in a poor location," Hughes said. "As the sweet spots become saturated, the amount of money you have to spend to keep the production rate flat goes up."

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Hughes estimates that drillers have worked their way through only about a quarter of the Bakken but said they have tapped about three-quarters of its sweet spots.

The Energy Information Administration projects that average production will continue to grow in 2015, reaching 9.3 million barrels per day and then slow to 9.5 million barrels per day in 2016. Hughes thinks U.S. producers could come close to the estimate this year, but average production in 2016 will fall short and come in below 2015 output.

Saudis win?

Cutbacks in the U.S. oil patch show that Saudi Arabia's poker game will be successful in the next few quarters, Olson said. In November, the world's top oil exporter declined to agree to output cuts that other OPEC members sought in order to put a floor under oil prices.

Instead, the Saudis have resolved to let crude prices remain low, which squeezes high-cost production in the United States.

"Their production is more convention, so they have lesser declines to deal with and more ability to put low-cost production on quickly," Olson said. "They are holding the cards."