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Falling rig counts unlikely to prompt significant declines in oil, gas production

Theupward trends in the price of natural gas and crude oil over the past one totwo months created expectations that rig counts have finally fallen far enoughto prompt an upward price response. However, migration of rigs to core acreageand the recent increase in hedging activity imply that production declines inthe U.S. could be limited.

Theprice of oil has gotten support since mid-February, when news broke late in theday on Feb. 11 that OPEC was ready to cooperateon freezing production levels. Trade that day created a short-term low in theMarch WTI futures contract at $26.05/bbl, and the market rallied up to a highof $41.90/bbl on March 22.

Naturalgas prices have advanced from a low of $1.611/MMBtu on March 4 to $2.015/MMBtuon March 30 as prospects for a tighter supply-demandbalance may limit storage additions over the summer injectionseason.

Thedeclines in rig counts along with signs of falling shale production in the ""have prompted the U.S. Energy Information Administration to reduce itsexpectations for U.S. oil production through 2016 and 2017.

Inthe latest "Short-Term Energy Outlook" published on March 8, the EIAprojected U.S. production of crude oil to fall from a peak in April 2015 of9.69 MMbbl/d to a low for 2016 of 8.21 MMbbl/d in September and a low in 2017of 7.95 MMbbl also in September.

Thedeclines were a drastic departure from what the agency had projected in itsfirst short-term outlook of 2015 when oil prices traded in the upper $40s andthe decline in prices was just seven months old. Production was shown to peakat 9.47 MMbbl/d in May 2015 and was forecast to fall to only 9.14 MMbbl/d inSeptember 2015 before rebounding and finishing 2016 with output of 9.91 MMbbl/d.

Whileoil production has been revised lower, dry natural gas output is forecast togrow more strongly than it was in January 2015.

Thedrastic change in the forecast for oil production has been the result of thenon-traditional nature of shale production. Such new developments and surpriseson the production side could eventually lead to higher output than currentlyexpected.

MorganStanley analyst Adam Longson said in a note on March 23 that the recent rallywould not be helpfulfor the supply cuts necessary to balance the market.

"Elevatedprices encourage producers to hedge current production, bring ondrilled-and-uncompleted wells (DUCs), and hedge future production, thusmitigating some of the production decline that one would otherwise expect,"Longson said. "Increased hedging volume is evident in CFTC data … and[investment grade] Permian producers are actively willing to hedge at $45-$50in 2017, which should cap the potential upside in prices."

In acolumn on March 22, the EIA showed that wells drilled since the start of 2014made up 48% of all U.S. crude oil production in 2015, and was up from 22% in2007. Production from tight formations — which include, but are not limited to,shale plays — accounted for more than 4 MMbbl/d, or 50% of total U.S. oilproduction.

Eventhough the decline curves for shale wells are steeper than conventional wells,the high initial production rates greatly reduce the concern over a drasticpullback in production.

Advancesin horizontal drilling and completion techniques led to growth in oilproduction from low-permeability tight reservoirs, according to the EIA.

Productionhas also remained elevated due to producer high-grading, or moving to thehighest profit, lowest risk drilling locations.

Theevidence of that is shown in rig count data in which Baker Hughes reports thatdeclines in some basins are much smaller than in others.

Sincea cycle peak in rig counts was made at 1,931 in the week ended Sept. 26, 2014,rig counts have fallen 1,467 to 464 rigs through the week ended March 24, or76.0%.

Excludingshale plays, which had a handful of rigs operating in September 2014 and havesince approached zero, the play with the largest percentage decline during theperiod has been the Mississippian, which has fallen from 77 rigs, or 90.9%, tojust seven.

Theoil-rich Eagle Ford and Permian plays are down 80.2% and 73.6%, respectively, duringthe period, and the gas-rich Haynesville and Marcellus have fallen 69.6% and62.5%, respectively.

TheCana Woodford inCentral Oklahoma has fallen much less than others as the South Central OklahomaOil Province, or SCOOP, has so-called sweet spots with thick pay zones, highlevels of initial production and low decline rates.

Thesmaller drop in rig counts in the play has also been the result of fallingcosts to drill wells not only in the Woodford but in all shale plays.

TheEIA said in a column on March 30 that costs per well increased from 2006 to2012 due to the rapid growth in drilling activity, but have fallen since 2012because of reduced drilling activity and improved drilling efficiency and tools.

TheEIA commissioned IHS Global Inc. to study costs on a per-well basis in theEagle Ford, Bakken, Marcellus and Permian regions.

"Upstreamcosts in 2015 were 25% to 30% below their 2012 levels, when per-well costs wereat their highest point over the past decade," the EIA said. "Changesin technology have affected drilling efficiency and completion, supportinghigher productivity per well and lowering costs, while shifts towards deeperand longer lateral wells with more complex completions have tended to increasecosts."

Market prices and includedindustry data are current as of the time of publication and are subject tochange. For more detailed market data, including powerand naturalgas index prices, as well as forwardsand futures,visit our Commodities Pages.