With the number of U.S. rigs drilling for oil and natural gas dropping by nearly 50% since October’s peak, analysts are focusing considerable effort to determine the ultimate impact on output. The market consensus seems to be that production will peak sometime this summer, roughly plateauing thereafter and growing again by mid-2016.
Could rig counts really fall this much while production, at worst, only flattens? With complete production data being quite lagged, many analysts are relying on the market’s experience in 2012, when natural gas rigs dropped sharply but natural gas production still managed modest growth.
We, however, find this analogue flawed. Why?
- U.S. natural gas production was partly saved by a rotation of rigs from natural gas plays to oil plays (reserves with higher oil content than natural gas content), which have associated natural gas production. In addition, natural gas liquids revenues supported the economics of many natural gas plays. With oil-directed drilling and oil prices falling sharply, the fall in rigs will be more meaningful to both natural gas and oil production (see chart).
- The migration from vertical to horizontal rigs helped drive efficiency improvements, but this rotation cannot occur again.
- The Marcellus basin is a game-changing low-cost supply basin that is now more mature, and it has no parallel in the oil space.
While we agree that efficiency gains are likely to continue and it is wise to use caution when extrapolating from rig counts to production, we expect the production response to be materially more meaningful in 2015 than in 2012. Although extrapolating production from the winter season is challenging, recent North Dakota data already show output exhibiting the slowest growth over the four months ending January outside of the polar vortex season in late 2013/early 2014. As evidence of a rapid slowdown in U.S. production growth becomes evident this summer, prices should find some support.