Oil drillers, not forecasters, are responsible for WTI weakness

The U.S. Energy Information Administration (EIA) is distorting oil prices by being far too optimistic in its forecasts for U.S. production, according to Harold Hamm, the chief executive of Continental Resources .

Hamm, who also chairs the Domestic Energy Producers Alliance (DEPA), a lobbying group, blames EIA for both the outright decline in U.S. oil prices and their underperformance compared with Brent since June.

Hamm faults EIA for being too optimistic about U.S. production, creating an impression there will be surplus of crude and depressing futures prices for West Texas Intermediate (WTI).

EIA currently forecasts U.S. crude production will climb to 9.69 million barrels per day (bpd) by December while DEPA predicts output will total no more than 9.35 million bpd.

“They need to get it right. If they don’t we see distortion happen. And we are seeing distortion happen right now,” Hamm said in an interview with Argus (“Continental CEO says EIA forecast caps WTI”, Sept. 27).

“The Brent-WTI spread is a good example. Here we are, within two months or three suddenly down to Brent by $6 per barrel … Certainly the two ought to be within a dollar or two,” he complained.

“Right here I see just if this correction is made and if the market realizes where we really are in America, I think there is a 20 percent adjustment (in prices) due right now.”

Hamm reiterated his view that prices below $50 are not sustainable and producers would need prices closer to $60 to meet rapidly growing global demand.

WTI-BRENT DISCOUNT

So is Hamm right to blame EIA for the decline in WTI prices and the big discount to Brent which emerged in the third quarter of 2017?

The relationship between front-month WTI and Brent prices was fairly stable between January and June, with WTI trading at a discount of around $2. As recently as June 30, WTI was trading at a discount of just $1.88.

Since then, however, the discount has widened consistently to reach $6.80. On Sept. 25, U.S. producers were receiving just $52.22 for benchmark crude while their counterparts in the North Sea were realising $59.

The gap hurts for U.S. shale firms, many of which are under intense pressure from shareholders to improve their profitability.

But it is not obvious that the market has reacted to EIA forecasts or that the agency should be blamed for the weakness of WTI.

There has been little change in EIA forecasts since June. In fact, EIA has recently trimmed its predictions for output in both 2017 and 2018.

ONSHORE OUTPUT

Hamm’s critique relates changes in drilling and completion rates to the whole of U.S. crude output, which he predicts will reach no more than 9.35 million bpd by the end of 2017 from 9.24 million bpd in July.

But drilling rates really only affect the onshore component of production rather than the more specialised and technically complex production from Alaska and offshore.

EIA forecasts production from the Lower 48 states excluding the Gulf of Mexico will average 7.08 million bpd in 2017.

The agency predicts Lower 48 output will reach 7.45 million bpd in December, which does not seem unreasonable given output was 7.05 million in July and had already climbed from 6.5 million at end-2016.

The rest of U.S. output comes from Alaska and the federal waters in the Gulf of Mexico, which produced 423,000 bpd and 1.8 million bpd in July respectively.

Both areas experienced production outages during the second quarter, which lowered output by 63,000 bpd and 123,000 bpd respectively between March and June.

But EIA is predicting both will boost output by December by 40,000 bpd and 100,000 bpd, which should ensure total U.S. output continues rising through the end of the year.

DRILLING SLOWDOWN

Hamm blames the agency for being slow to react to the slowdown in drilling and well completions that started in the second quarter.

“We knew that production is not growing like the EIA is saying. It was coming down. Rig count was turning over and so were well completions,” Hamm told Argus.

DEPA surveyed all the publicly reporting oil and gas companies that reported in the second quarter and found that capital expenditure and production forecasts had been cut.

But the rig count and well completions declined precisely because of the drop in oil prices from late February onwards.

If WTI prices had not fallen from their peak in late February, it is likely that drilling rates would have continued climbing.

The fall in WTI prices was a necessary signal to ensure domestic oil producers changed their drilling and production plans.

Experience shows drilling and completions typically respond to a fall in WTI prices with a delay of around 16-20 weeks.

In response to the decline in prices after February, the frenzied drilling boom began to moderate during the second quarter.

But the rig count did not actually flatten out and begin falling until late July or early August, according to oilfield services firm Baker Hughes.

Production tends to follow changes in drilling with a lag of up to six months, so the rise in drilling until June is likely to continue increasing output through the end of 2017.

Based on the rising rig count during the first six months of the year, it is not unreasonable for EIA to predict U.S. oil production will continue growing through year-end.

WELL COMPLETIONS

There has been a notable slowdown in onshore well completions, as Hamm noted, which does seem to be moderating production despite the earlier drilling boom.

The phenomenon is most pronounced in the Permian Basin, where the number of wells drilled per month increased from 373 in January to 488 in August, but completions were up from just 242 to 353.

The result is a lengthening backlog of drilled but uncompleted wells (DUCs), which has grown from 1,500 in January to almost 2,300 in August, according to EIA.

Some completions have been deferred by companies hoping for an increase in oil prices while others are waiting because of a shortage of fracking crews and equipment.

If the slowdown in completions is sustained, it will moderate the increase in onshore oil production in the remainder of 2017.

But the slowdown in completions is itself mostly a response to the decline in WTI prices during the second and third quarters.

EIA should not be blamed for price declines which was a necessary market signal to tame the drilling and completion boom and adjust U.S. oil production to a more sustainable course.