U.S. Oil Output Cuts Could Take a While

Saudi Arabia effectively started a global oil price war this month aimed at quickly denting U.S. oil output. Slowing a U.S. drilling boom, however, could take more than a year.

Many observers expect a downward spiral of global oil prices to rapidly dampen shale oil drilling in the United States, slow production growth and help bolster prices. Small producers vulnerable to sudden price moves may have to slow spending, fast reducing the amount of oil gushing to market.

But even as drillers consider cutting budgets for 2015, output may continue to grow through next year and possibly into 2016, according to experts and industry insiders.

Existing wells that are drilled but not yet fracked will keep output surging for months, they said. Many drillers have long-term rig contracts and are loathe to pay costly penalties for dropping equipment they could need soon after. Most have hedged next year's production at much higher prices, and are racing to lock in 2016, protecting their revenues even if the free-fall in oil markets continues.

At stake is not just the fate of a U.S. drilling frenzy that has transformed the North American energy picture and powered the U.S. economy, but the shape of the global market as OPEC leader Saudi Arabia hopes to claw share from U.S. producers.

Saudi Arabia has privately told the oil market that it is willing to allow prices to slide as low as $80 for a year or two, in a move seen aimed at U.S. producers. Kuwait and Iran have since said that they have no plan to cut production. That is putting pressure on companies like Continental Resources (CLR) and EOG Resources (EOG) whose share prices are unraveling.

A four-month rout in oil markets that has knocked Brent crude to $85 a barrel, its lowest level in four years, poses the first major challenge to the U.S. shale sector since it emerged four years ago and sent oil output to its highest in a generation.

Much depends on how the industry responds to an unfamiliar environment of lower prices. The shale revolution has been driven by hundreds of disparate U.S. companies drilling thousands of new wells.

"It is like turning an aircraft carrier - you can't do it on a dime," said Roland Burns, chief financial officer of Comstock Resources in Frisco, Texas, which has operations concentrated in Texas, Louisiana and Mississippi.

MORE RIGS THAN EVER

Until now, the small- and medium-sized companies driving the oil boom have rarely looked beyond drilling and drilling more.

Oil rigs in North America hit an all time high of 1,609 last week, up 17 percent from a year ago, according to a weekly survey by oil service firm Baker Hughes. U.S. output is the highest in 30 years, thanks to output from newly-tapped and prolific shale formations.

To be sure, many producers who are now preparing their capital budgets for next year are likely to consider scaling back. Some have seen their share prices tank on concerns they may be over-spending in a low-price year.

Wells Fargo (WFCNO) analysts this week said they expect U.S. exploration and production spending to be flat next year versus 2014. Due to the rapid 70 percent decline rate in shale oil wells after the first year, flat spending would cut shale production growth to just 200,000 barrels per day. U.S. oil output has surged by 1 million bpd in each of the past three years.

Comstock Resources may cut its five oil-drilling rigs down to three next year, Burns told Reuters. Magnum Hunter Resources , an oil and gas producer with acreage in some of the major U.S. shale plays, divested some of its oil assets earlier this year, fearing a decline.

"There is no question that lower prices will affect the oil business. You will see a change in direction by some companies," Chief Executive Gary Evans told Reuters.

TIME TO FEED THROUGH

But even if spending declines, some say, it will take time for that to translate into a substantial slow-down in output.

A backlog of oil wells that have been drilled but yet to come online could keep output steady. In North Dakota, where crude from the Bakken formation is now below $80 a barrel, there were about 630 wells waiting to be hydraulically fracked at the end of July, a backlog of at least three months.

"It is not as though oil goes to $75 and everyone just panics," said Mark Hanson, an energy analyst at Morningstar (MORN). Prices would have to remain below $75 a barrel for a prolonged period before drilling slows. Some plays are profitable as low as $50 a barrel, he said, let alone $80.

Many companies have also already locked in their 2015 hedges at higher prices that will make next year's output profitable, according to company presentations.

Some nervous producers are now moving gradually to sell 2016 too, even with prices for that year having tumbled from $89 to $81 a barrel in three weeks, according to Andy Lebow, senior vice president at brokers Jefferies LLC.

Genscape analysts expect the oil rig count to fall by 300 by the end of 2015, but even that would only slow oil production growth to some 600,000 bpd, according to their models. That's nearly enough to meet the increase in global demand this year.

Reporting By Edward McAllister