Digging into Crude Oil Prices 2.0

Dean Foreman
Posted February 8, 2022

Lots of people want to know: If the International Energy Agency (IEA) and the U.S. Energy Information Administration (EIA) both project that global crude oil supply could outpace demand this year, then why were crude oil prices above $90 per barrel for Brent crude at the end of January, their highest level since October 2014?

By economic fundamentals, if supply does not outpace demand as the energy agencies expect, historically that could result in continued upward pressure on crude oil prices. 

Given those official forecasts, it’s also fair to ask what’s primarily driven the cost of crude oil, which of course is the leading factor in pump prices that averaged $3.42 per gallon for all grades of gasoline the last week of January, compared with $2.47 per gallon the last week of January 2021, a 38% year on year (y/y) increase.

Good questions. Basically, as we’ve been pointing out, demand has continued to outpace supply to date, though energy agencies project this to change. Let’s look at the IEA and EIA projections. IEA suggests global supply could rise by 6.4 million barrels per day (mb/d) in 2022, compared with a 1.5 mb/d rise in 2021. EIA similarly projects a global oil market surplus beginning in the first quarter of 2022. Meanwhile, Reuters reported recently that U.S. drillers added oil and gas rigs for a record 18^thconsecutive month and suggested the number could grow in 2022.

Timing matters. Given enough time for drilling to result in production, we could see an increase in prospective supplies in line with those official projections.

Historical context could matter. The reported drilling increases, based on data from Baker Hughes as of Jan. 28, show that numbers of active U.S. drilling rigs rose during the week by four for a total of 495 rigs pursuing oil and by two rigs for a total of 115 pursuing natural gas. While these activity levels have more than doubled since their low points during the 2020 COVID-19 recession, they still were down 43% for oil and 42% for natural gas compared with the same week in January 2019, preceding COVID and the record highs in U.S. oil production.

As a back-of-the-envelope comparison, if last week’s pace were extended, adding four oil rigs per week consistently through the end of 2022 would raise the U.S. back to 687 oil rigs at year’s end – basically on par with its level at the end of 2019. However, even with this growth, average oil rig activity for 2022 would be about one quarter less than it was in 2019, when it was leading to record U.S. production.

We should also consider the productivity of well completions and how much the inventory of drilled but uncompleted wells (DUCs) could contribute to production. In 2021, EIA reported that about one-third of oil and natural gas well completions were DUCs, rather than newly drilled wells, but this varied greatly by region.

The main U.S. oil-producing regions – the Permian, Bakken, DJ Niobrara and Eagle Ford – relied even more heavily on completing DUCs in 2021. By comparison, in Appalachia, the largest dry natural gas-producing basin, one in five well completions came from DUCs. However, the inventory of DUCs was drawn down by 40% (y/y) as of December 2021, by EIA estimates. Since this inventory was accumulated over many years, it is not clear if these estimates are precise or if their well productivity, once completed, could be more or less than newly drilled wells. But with fewer DUCs remaining, this generally suggests that more organic drilling activity could be needed to support production growth.

The utilization of DUCs also has important implications for our understanding of rig productivity. EIA estimates the total amount of oil and natural gas production per rig based on all well completions, including DUCs. Consequently, the underlying rig productivity could vary, depending on how many DUCs have been completed and the quality of these wells.

For example, when we back out DUC well completions while assuming that all new well completions in a given month were equally productive (as we have done in the quarterly API Industry Outlook presentation), it appears that the underlying well productivity initially rose in mid-2020 as producers drilled their best prospects using their most productive crews, but it has broadly slipped since then. 

The quality of all DUCs also may not be created equal. For example, if these wells were originally drilled to retain leased tracts (as required by lease terms), they might not have been located to optimize current production. Alternatively, if they were in areas that appear to be very prospective for oil and natural gas production but happen to be located very distant from the existing pipeline infrastructure at the time, the DUCs could turn out to be strong producers. 

One thing that is clear, however, is that depending on DUCs to meet growing demand cannot last forever. In the Permian basin, for example, EIA estimates that the number of DUCs fell by 52% y/y to 1,446 in December 2021 from 3,021 in Dec. 2020, so for producers in the region to complete another 4,600 wells or more in 2022 would require drilling new wells.

Yet, as we’ve been saying, there’s still a significant gap in drilling activity today compared with 2019, and there are uncertainties about DUCs and how much production they could contribute. If drilling continues to be unable to return to its 2019 levels – whether due to work force, supply chain, financial or energy policy headwinds – the result has been a continued dearth of domestic oil production relative to its peak levels in late 2019 and early 2020. Less domestic oil production has led to lower crude oil inventories, a return to U.S. petroleum net imports, and ultimately upward pressure on prices. 

These are the key factors to monitor when tracking production versus official projections.