Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

It's Zootopia time in the oil market.

The bears are in charge and the bulls are being menaced by, of all things, a stray kitten (see this).

Now they've got another problem: a flock of DUCs lurking in the shadows.

In the oil and gas industry, "DUCs" is shorthand for drilled but uncompleted wells, where a hole has been punched into shale rock but the operator hasn't yet fracked it in order to start production.

And in the major oil-producing basins, the DUCs are on the march:

DUC Tales
The inventory of uncompleted wells in America's major shale oil basins has surged in the past year, mainly in the Permian region
Source: Energy Information Administration

One reason for this is simply that E&P companies are putting more rigs back to work:

Driller Thriller
The number of rigs drilling for oil in the U.S. has more than doubled in the past year
Source: Bloomberg

The vast majority of the DUCs reside in the Permian basin. Apart from the frenzy of drilling, the higher DUC count there likely reflects logistical bottlenecks. There isn't much point in completing a well if there isn't a spare pipeline to take it, for example. The local price marker trading at a discount to the benchmark Nymex futures price suggests a local glut building up:

Stuck In The Midland
Permian barrels have traded below benchmark futures prices for most of the year so far
Source: Bloomberg

This dynamic may be distorting the market's view of a critical issue: Permian productivity.

This prolific shale basin has been the engine of recovery for U.S. oil output in the face of lower prices. Yet, as shown by the Energy Information Administration's latest report on this, released earlier this week, oil output per rig in the Permian fell last month to its lowest level since March 2016:

Moderate Rock
Permian oil production per rig has fallen by 11 percent in the past year
Source: Energy Information Administration

For oil bulls, that chart is a welcome sight. But it could also be misleading because of those DUCs.

If rigs are rampant but completions are calmer, then by definition the output of oil per rig declines. This chart shows how the number of rigs running in the Permian has changed since December 2013 -- when the EIA's data start -- along with the output per rig and the number of DUCs, all indexed to 100 for comparison:

DUC And Smother
The apparent drop in Permian oil productivity is largely explained by the surge in DUCs
Source: Energy Information Administration
Note: Data are indexed to 100 for comparison.

It is true that there are some signs of productivity topping out when it comes to how many wells are being drilled by the average rig every month:

Settling Down
The number of wells drilled per rig in the Permian basin has stopped growing, but at 1.27 in May it remains around the 12-month average
Source: Rystad Energy

Again, however, it pays to look beneath the headline number.

For one thing, wells are getting longer, so a simple count doesn't capture the full story. The average lateral length of a well in the Permian basin -- that is, the part of the well that snakes sideways into the shale rock for fracking -- hit almost 6,600 feet in the fourth quarter of 2016, according to Bloomberg Intelligence, up 11 percent in the space of two years. Some wells now stretch to more than 10,000 feet in length (that's a big reason why E&P companies with adjacent land decide to merge assets; think longer straws in a bigger milkshake).

Moreover, operators are constantly tweaking the inputs that go into the actual completion of the well: how many stages (or portions) of it will be fracked, how much water will be pumped in, how much sand will be used to keep the shattered shale rock propped open to allow oil to escape, and so on.

It is this last point that gets to why the DUCs should really haunt OPEC's thoughts.

Because those uncompleted wells are like inventory for a manufacturer. One way to think about this is to compare the total number of DUCs with the average number that get completed each month. This gives you a sense of how many months' worth of wells are sitting on the industry's books:

The Warehouse
Across the major shale oil basins, there is now more than seven months' worth of wells awaiting completion, up from about two months' worth before the crash
Source: Energy Information Administration, Bloomberg Gadfly analysis
Note: Data calculated as number of DUCs divided by number of wells completed that month.

Say that average inventory was taken back down from the current level of about seven months' worth to a more normal level. It's impossible to say what "normal" is these days, but say it was five months. That would imply there are roughly two months' worth of excess DUCs in the four major shale oil basins, or almost 1,600 in total.

How much potential oil production does that represent? To answer that, first we need to know how much oil a typical new well produces in its first year after completion. The ranges are very wide between individual wells, but here are averages provided by analysts at Wood Mackenzie for 2016:

Start Me Up
The average new well completed in the major shale oil basins produces roughly 150 to 350 barrels a day in its first year
Source: Wood Mackenzie
Note: Data are for wells completed in 2016.

Using these data, we can take a stab at what the added production from each shale basin would be if the excess DUCs were run down to a more normal amount. This chart shows the implied production if that level fell to three, four, or five months' worth:

Swimming In Oil
The DUCs represent hundreds of thousands of barrels a day of potential oil production
Source: Energy Information Administration, Wood Mackenzie, Bloomberg Gadfly analysis
Note: Data show implied extra oil production for the first year from completing all excess DUCs above three-to-five months' worth of inventory, based on June 2017 activity levels.

Those DUCs aren't necessarily going to suddenly be completed and start producing oil all at once -- certainly not with oil at less than $50 a barrel. And at least some of this is already factored into forecasts for U.S. oil output.

But like potential energy, the DUCs are there and can be released when the right switches -- around prices, capital and available infrastructure and labor -- get thrown. Investors expecting a big recovery in oil prices in 2018 should bear that in mind.

OPEC's biggest challenge isn't that there is more oil beyond its borders. That's always been true. Rather, it is that U.S. shale, in particular, can achieve productivity gains by learning rather than just via scale and, crucially, can respond relatively quickly to market signals.

In other words, even if OPEC succeeds at raising oil prices, it would awaken that army of dormant DUCs.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net