In the span of five weeks, a roaring bull market for oil has given way to a sharp downturn. Fears that U.S. sanctions on Iran would cause a global oil shortage have been replaced with worries that the market is oversupplied. Prices for both WTI and Brent crude -- the U.S. and international benchmarks, respectively -- have plunged about 20% since early October.
This article originally appeared in the Motley Fool.
Rising U.S. output played a big role in popping the recent oil price bubble. Some oil-producing countries are now considering production cuts to reverse the recent drop in oil prices.
In the short term, production cuts by OPEC and its allies could drive up prices. But in the long run, any such moves would be self-defeating. U.S. oil production is primed to keep skyrocketing -- and the higher oil prices go in the short term, the bigger the jump in U.S. output will be.
U.S. oil production is flying higher
Last week, the U.S. Energy Information Administration reported that U.S. oil production hit a new high during the week that ended on Nov. 2. Domestic production reached 11.6 million barrels per day (bpd), up from just 9.6 million bpd a year earlier. Year to date, U.S. production has averaged 10.7 million bpd, up from 9.3 million bpd during the same period in 2017.
The rapid growth in output is particularly remarkable because some of the main oil production regions -- particularly the prolific Permian Basin -- haven't had enough pipeline capacity. As a result, the price of crude oil in Midland, Texas, in the heart of the Permian Basin, has traded at a discount of as much as $18 per barrel to the price of WTI at the main Cushing, Oklahoma, hub. Meanwhile, WTI has traded at a discount of $8 to $10 per barrel relative to the international Brent crude benchmark recently.
That means U.S. producers have ramped up output even though many of them have been getting less than $60 per barrel for most of the year, far below the global market price of oil.
Growth isn't about to stop
Normally, a steep drop in global oil prices might cause U.S. producers to pull back. However, that's not likely this time. Earlier this month, Plains All American Pipeline (NYSE:PAA) started up its expanded Sunrise pipeline. Initial volumes of 300,000-350,000 bpd are about 100,000 bpd higher than Plains All American's previous estimate. This performance has already caused the discount of Midland crude relative to WTI to narrow considerably.
The Sunrise pipeline is just the first of several set to ease the Permian Basin's pipeline constraints over the next couple of years. As my colleague Matthew DiLallo noted back in September, a second Plains All American pipeline will start up in the third quarter of 2019, followed quickly by as many as four more new pipelines over the following 12 months.
Assuming all of these projects are completed on schedule, they could add about 4 million bpd of additional pipeline capacity to move crude from the Permian Basin and Eagle Ford shale to market by the end of 2020.
This development will unlock further production growth. First, while the U.S. oil rig count is still well below the highs seen in 2014, the rig count has nearly tripled since May 2016, and efficiency has improved dramatically over the past few years.
CaptureU.S. oil rig count, data by YCharts. Photo: The Motley Fool
Second -- and even more importantly -- there are a huge number of drilled but uncompleted wells in the Eagle Ford and Permian areas. By the end of August, the two regions combined had 5,175 drilled but uncompleted wells that were waiting to be fracked, up from fewer than 2,500 in late 2016. Increased pipeline capacity will allow producers in those areas to get better prices relative to global benchmarks, which are likely to fuel a surge in well completions -- and thus output -- over the next few years.
OPEC production cuts won't fix the problem
With oil prices having dived since the beginning of October, Russia and Saudi Arabia -- now the No. 2 and No. 3 oil producers in the world, behind the U.S. -- are feeling pressure to reduce their production in order to stabilize the market. Representatives of the OPEC nations, Russia, and several other oil-market allies are meeting this weekend and could discuss such measures.
These swing producers can influence prices by artificially capping oil supply, but doing so is a dangerous game. The more Russia, Saudi Arabia, and their allies drive up prices now, the more profitable it will be for U.S. producers to boost production.
OilA pumpjack sits on the outskirts of town in the Permian Basin oil field in the oil town of Midland, Texas, Jan. 21, 2016. Photo: Spencer Platt/Getty Images
With oil demand growth slowing, it's entirely possible that U.S. production alone will increase more than global demand in the next few years. To keep oil prices high, OPEC and its allies would have to keep reducing production further and further. In the short term, that might be an option, but it's clearly unsustainable in the long term. Sooner or later, oil prices will move toward levels more in line with market forces, which could be even lower than current prices.
What it means for investors
The profitability of U.S. oil producers over the next few years will depend in large part on what OPEC and its allies do. If the latter reduce output to push up prices, then oil companies could enjoy bumper profits -- but if they allow market forces to work, oil prices could continue falling, weighing on oil companies' earnings growth.
Thus, midstream companies such as Plains All American could be a safer bet on the U.S. oil boom. One thing that seems clear is that inland oil production has a lot of room to grow, which means producers will need to move a lot more barrels to refineries and export facilities, mainly along the Gulf Coast. That should drive solid revenue and earnings growth over the next few years for Plains All American and other pipeline operators.