A Paradox Reveals an Important Trend in U.S. Oil Production

The past year was an interesting one for the energy industry. Faced with incredibly low natural gas prices in the first half of the year, an increasing number of North American energy companies pulled rigs from natural gas, choosing to focus instead on crude oil.

While the oil-directed rig count ended the year higher than it did in the year-ago period, even rigs drilling for oil saw a steady decline each month starting in August of last year. Yet despite this decline, U.S. crude oil production ended the year on a high note and continues to rise. Let's take a closer look at this apparent paradox and the major trend in domestic energy production that it highlights.

An apparent paradox in the oil and gas production data
Last week, the U.S. rig count fell for the eighth week in a row to the lowest level since March 2011. The number of rigs drilling for oil fell by seven to 1,316 last week, while the number of rigs drilling for gas declined by five to 429, according to Baker Hughes data.

The data present an apparent paradox. Since August of last year, the oil-directed rig count has fallen every month, yet oil production is stronger than ever. According to the Energy Information Administration, domestic crude oil output increased by 39,000 barrels per day to 7.04 million last week, which represents the highest production level since 1993.

How can this be if the number of rigs has been in steady decline?

Explaining the paradox
The main reason is major technological efficiencies that allow firms to maximize output with fewer rigs. Faced with rising cost pressures that have made the marginal barrel of oil more costly to extract, operators have increasingly sought cost improvements to offset the rising expenses associated with production. For instance, Whiting Petroleum (NYSE: WLL  ) has been replacing existing rigs with pad-capable drilling rigs, which are more efficient and allow the company to drill the same number of wells with fewer rigs.

Another major trend has been the drastic reduction in the amount of time it takes to drill a well. In fact, hundreds of energy companies have seen drastic reductions in drilling days thanks to incremental improvements in technology.

For instance, an improved control system for managed pressure drilling introduced by Weatherford International (NYSE: WFT  ) led to a sharp reduction in drilling days for Forest Oil, a Denver-based independent oil and gas company. During its initial application, Weatherford's technology, called the Microflux control system, allowed Forest Oil to cut the number of drilling days in the Haynesville Shale from 31 to 16.

A lot of these and other technological improvements have been introduced by oil-field services firms like Weatherford, which consistently pour tons of money into research and development. Schlumberger (NYSE: SLB  ) , for instance, shelled out more than $1 billion for research and development in 2011.

Many other companies have also realized meaningful cost savings through employing longer laterals and optimizing the fracking process, which can include varying the number of "frac" stages, to maximize the total quantity of hydrocarbons recovered. The focus on maximizing output through efficiency is a relatively new development, driven by quickly rising marginal production costs.

How the efficiency trend took off
According to Doug Sheridan, managing director at EnergyPoint Research, the focus on efficiency accelerated after Helmerich & Payne  (NYSE: HP  ) , a major equipment provider to the energy industry, introduced its FlexRig series in the early to mid-2000s.

The FlexRig is a computerized drilling rig that permits the operator to move more quickly and efficiently between drilling locations. The innovative rig utilizes variable frequency drives and computerized drilling technology that can control major aspects of the drill bit, such as the amount of torque and drilling fluid pressure.

When designing the FlexRig, the company had one major goal in mind – to create a highly efficient and safe drilling rig. The value proposition eventually paid off, attracting the interest of dozens of energy companies.

Some of the earlier adopters of FlexRig were Williams Companies and Devon Energy (NYSE: DVN  ) , both Oklahoma-based energy firms located within close geographical proximity of Helmerich & Payne's Tulsa headquarters.

Williams attested that FlexRigs saved time and, hence, money by allowing quick movement from well to well. Even though the FlexRig commanded a premium day rate compared to conventional rigs, it generated meaningful cost savings for the Tulsa-based energy firm. According to a Williams spokeswoman, Susan Alvillar, the company's expenses were 5% less using the FlexRig as compared to a conventional rig.

Devon Energy also saw significant cost savings from converting to FlexRigs. In its operations in North Texas' Barnett Shale, the company's drilling manager David Fortenberry calculated per-well cost savings of $200,000. Since energy companies spend tens of thousands of dollars per day on a rig, a reduction in the number of drilling days can lead to substantial savings. Devon also acknowledged that the FlexRig was significantly safer – by up to five times as per Fortenberry's estimates – than conventional rigs.

Final thoughts
As fields of "easy oil" have quickly been depleted over recent decades, energy companies have increasingly turned toward unconventional sources, including shale and deepwater. While these sources are expected to contain vast quantities of oil and gas, associated production costs can often be exorbitantly high.

To attempt to offset the higher costs, energy companies have tried to do things as efficiently as possible. This trend is unlikely to change any time soon and should continue to benefit oilfield services firms, which provide the necessary expertise and equipment to drill in shale and deepwater reservoirs, as well as equipment providers like Transocean, which offer contract drilling services to energy firms worldwide.

As long as the price of oil remains high enough to incent exploration and production companies to drill, oilfield services and equipment providers should continue to see high global demand for their products and services.

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