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OPEC's Decision to Maintain Output Poses Dilemma for U.S. Shale Operators

The oil minister of Saudi Arabia last week successfully argued against reducing OPEC oil output by telling fellow members they needed to combat the growing influence of U.S. shale oil production. Now oil markets will have to find a "new equilibrium," with the squeeze on U.S. producers, said analysts.

Although some OPEC oil ministers wanted to reduce output, Saudi Arabia's Ali al-Naimi persuaded the group last Thursday to hold fast on oil output, despite the double-digit decline in oil prices since June. OPEC agreed to maintain its ceiling of 30 million b/d, which is at least 1 million b/d above its estimate of demand for oil in the first half of 2015.

The news provoked a big sell-off in crude on Friday, sending Brent and West Texas Intermediate (WTI) prices to four-year lows. It also led to a massive sell-off in some U.S. exploration and production companies, as well as ancillary industries that included railroads and pipelines.

Barclays analysts said the OPEC meeting, and the oil ministers' decision to not cut production "marks a watershed for the oil market." OPEC "is clearly signaling that it will no longer bear the burden of market adjustment alone and this decision puts the onus on other producers, especially U.S. tight oil to adjust as well...

"Over the course of the coming months, oil markets will have to find a new equilibrium -- a world where demand elasticities are tested, and non-OPEC supply sensitivities, and particularly the pain threshold for U.S. producers becomes better understood. At least another 1 million b/d of cuts looks necessary to balance the market, in our view."

Given market skepticism that recent price levels are low enough to slow U.S. output growth, Barclays expects prices to drop below $70.00/bbl for Brent and even lower for WTI.

How quickly supply and demand respond is a "key question," said Barclays analysts. "We believe that the fundamental oversupply will take up to a year to clear, but we are already a quarter into the price adjustment." Unlike the financial meltdown of 2008-2009, "oil demand does not face equivalent headwinds."

Barclays anticipates that supplies outside of OPEC likely will adjust in the next six months, leading to prices of about $80/bbl in the second half of 2015.

"Though the oil industry is entering a new phase of lower prices, cost pressures on unconventional supply are likely to lead to enhanced productivity and capital discipline in the years ahead," said the Barclays team. "If OPEC has truly abdicated its role as a moderator of price swings, only with pain will OPEC and tight oil producers gain in the long run."

Analysts already had been warning of a pullback in North American basins as Brent/WTI prices declined in the past few weeks. Tudor, Pickering, Holt & Co. (TPH) and others identified the most vulnerable plays as the Tuscaloosa Marine Shale; the Permian Basin's Cleveland, Tonkawa and Marmaton formations; the Mississippian Lime, and fringe targets in the Eagle Ford and Bakken shales (see Daily GPIOct. 28).

The dismal performance by oil and gas stocks on Friday "was far from the worst energy stock performance day in the past 15 years," with 10-plus more worse days, but most of those worse days were during the financial meltdown of 2008-2009, noted TPH analysts. The "spot oil price can kind of be whatever it wants for a little while now...OPEC isn't meeting for another six months, global production response takes time, and the first half of 2015 is the main oversupply period that further drags on sentiment. But make no mistake, the current oil price is going to crunch supply by late 2015/2016."

ClearView Energy Partners LLC models imply about "six months of 'braking distance' between a global crude price collapse and a U.S. drilling slowdown," said analysts. They used trailing, 12-month average monthly output growth figures through October for the Permian Basin, Niobrara formation and Bakken and Eagle Ford shales -- the four U.S. basins with the most oil output. Those figures imply that in 2015, oil production should grow around 1,068,000 b/d.

However, using a Brent price of $75.00/bbl, the "historical relationships between price and production imply that four-region growth could be as low as 584,000 b/d."

Lower crude oil prices wouldn't only dampen onshore oil output, but it could undermine "the business case" for U.S. liquefied natural gas as an alternative to crude-linked prices in overseas destination markets, according to ClearView. In addition, the slowdown in oil output would reduce associated gas output.

Societe Generale's Michael Wittner said prices will "need to go down to production cost levels for U.S. shale oil, and stay there for an extended period." He had been expecting OPEC to cut production, but the meeting "leads us in the direction of our bearish scenario, with prices of $70 Brent/$65 WTI for two years (2015 and 2016). Why those levels? Most U.S. shale oil costs WTI $65 (on a WTI-equivalent basis), if not lower."

Wood Mackenzie updated its forecast and now expects crude oil to remain under downward pressure "as the price explores what it needs to slow supply growth."

The market "will test the U.S. tight oil price floor, act to slow medium-term oil supply growth beyond the U.S. and challenge OPEC resilience to hold to its current production levels," according to Wood Mackenzie. "For U.S. tight oil, our detailed breakeven price analysis shows by end 2015, such prices could lead to at least 0.6 million b/d being removed from the market, which would curb the over-supply situation.

"Importantly, these prices would also send a sharp signal to the industry and have an wholesale effect on future spending plans, which will feed through to oil prices as a supportive factor."

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