If crude prices rise, US output growth will accelerate. But the response cannot be as quick or as large as for the OPEC countries

Ed Crooks, Vice-Chair, Americas, Wood Mackenzie

Nassim Nichola Taleb, the great theorist on risk and uncertainty, tells a parable about turkeys living on a farm. They get fed every day, and life seems good, until Thanksgiving arrives when they sharply revise their views about the world. The point of the story is that apparently rare events can have extreme consequences, and it makes sense to protect yourself against those risks if you can.

The possibility of one of those “tail-risk” events hitting the world economy has risen in recent weeks as a result of the escalating conflict in the Middle East. As my colleague Simon Flowers, Wood Mackenzie’s Chief Analyst, wrote last week, there is a potentially large threat to global oil supplies if strikes target essential infrastructure and/or the Strait of Hormuz is closed to tanker traffic.

For the US, the strength of its domestic oil industry might look like an important safeguard against the impact of such a supply shock. The US is now by some distance the world’s largest oil producer, with output this year averaging about 13.2 million barrels a day of crude.

The US industry has shown that short-cycle production can respond relatively quickly when market conditions are right. Over the past three years, the US has added about 2 million b/d of additional tight oil production. In 2017-19, it added about an extra 3 million b/d in just two years.

Indeed, the strength and flexibility of US oil output has led to suggestions that the nation’s Strategic Petroleum Reserve (SPR), launched in 1975 as protection against external supply shocks, is now redundant and should be sold off.

That is not a consensus view in US politics. Under the Biden administration, between January 2020 and July 2023, the oil held in the SPR dropped by about 288 million barrels, as a result of a combination of emergency sales and scheduled sales mandated by Congress.

However, the administration has since then been buying back oil, partially refilling the reserve. As of September, the Department of Energy had purchased over 50 million barrels, at an average price of about US$76 per barrel, compared to an average price of US$95 for 2022’s emergency sales.

Under its commitment to the International Energy Agency, the US has pledged to maintain 90 days of cover for its net imports of petroleum, in government and private stocks. But it is currently a net exporter, and on Wood Mackenzie forecasts, is set to remain in that position for decades, so the commitment does not require any particular level for the SPR.

A rise in oil prices can still cause economic damage in the US, driving up inflation and cutting consumers’ real incomes. Even if, at the aggregate level, the total effect on GDP is neutral or positive, the distribution of the impact across the US can still be a problem.

Higher prices also hit US trading partners and allies around the world that are net importers, delivering a shock to the world economy. So, the US, in general, has an interest in smoothing out any price spikes if it looks like oil is moving too far and too fast.

The question is whether the US tight oil industry can provide sufficient supply flexibility to play that role, obviating the need for government-controlled reserves such as the SPR.

Wood Mackenzie view

When crude prices rise, short-cycle tight oil can certainly respond much more quickly than offshore production that needs exploration, appraisal and development taking many years. On average, the time from stepping up US onshore drilling and completion activity to increased production is about six months. But there are two key constraints that can restrict producers and limit any ramp-up in activity in response to market conditions.

The first is investors’ expectations. Over the past four years or so, shareholders have been demanding capital discipline from E&P companies. At least initially, any rise in oil prices would be seen as an opportunity to strengthen free cash flow, rather than step up activity.

Alex Beeker, Wood Mackenzie’s research director for corporate research, says that with West Texas Intermediate (WTI) crude at around US$70 a barrel, which was where it was in September, US E&Ps’ average reinvestment rate was rising to about 70% of their operating cash flow, up from 62% in 2023. As oil prices rise, the first response is to let that reinvestment rate fall again, creating more headroom for using cash for distributions to shareholders.

The other constraint is in the supply chain. Utilisation rates for the most highly specified rigs and for dual fuel and electric pumps for hydraulic fracturing are running above 90%. Attempting to ramp up activity rapidly would run into availability problems and drive up costs in the supply chain.

Nathan Nemeth, Wood Mackenzie’s principal analyst for Canadian and Lower 48 unconventionals research, did some modeling in August to estimate the impact that oil price changes might have on US production.

His conclusion was that if WTI were to average US$90 a barrel next year, about US$10 above our base case forecast, we would expect US tight oil production to be about 550,000 barrels a day higher.

With US producers typically taking about three to five months to respond to a change in prices, the full impact on production would come about eight to 12 months after the move in WTI.

That increase in production is not trivial, and would play a role in moderating any rise in crude prices. When people talk about the US as “the new swing producer” of oil, they are not entirely off-base.

But there is a big difference between that kind of production growth and the rapid responses that can come from Saudi Arabia and other members of OPEC that have been curbing production. Saudi Arabia, the United Arab Emirates and Kuwait can bring the great majority of their spare capacity into production within 30 days.

It is also very different from the response that is possible from the SPR, which has a maximum drawdown capacity of 4.4 million b/d and can get oil into the market just 13 days after a presidential decision.

The US has some protection against disastrous tail risk events in world oil markets. But thinking it is completely immune from any adverse impact would be like being a turkey living in blissful ignorance of Thanksgiving.

In brief

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Original article   l   KeyFacts Energy Industry Directory: Wood Mackenzie