Photo credit: Flickr user William Gray

One of the best ways to understand what's going on in the oil market right now is to have a better understanding of how an oil reservoir actually works. These oil fields, and oil wells in particular, are the key to supplying the world's oil demand. As we've seen in the past, when supply or demand goes out of balance it can cause oil prices to do crazy things.

There really is no better company to explain what goes on inside an oil reservoir than Core Laboratories N.V. (NYSE:CLB). The company specializes in understanding the inner workings of an oil reservoir as it helps oil companies optimize the development of oil deposits. Because of the company's expertise in what happens down-hole, it can offer us a clue on how quickly the oversupplied oil market could work through its issues. 

Refresher on economics 101
The oil market is largely fueled by supply and demand. The world's economies need oil, and oil producers are happy to supply it at a profit. However, sometimes oil producers can't keep up with demand, as oil supplies are tough to maintain. This causes prices to spike, which entices more entrants into the market. Then there are times when oil producers go overboard and pump out more oil than the world needs. That's where the market finds itself today.

In Core' Labs latest earnings release it detailed the current oversupply issues in the market.

...crude-oil supply and demand markets are imbalanced with crude production exceeding worldwide demand by approximately 1.0 to 1.5 million barrels per day or MMbopd. This imbalance is not only due to increased supply, mainly from North American unconventional developments, but also to significant decreases in demand, primarily from Asia Pacific markets, and to lesser demand from Europe. Core Lab believes these market imbalances will be transitory in nature, as was the case in 2009.

There are a couple of important things worth noting from what Core Labs has to say about the current state of the oil market. First, we're oversupplied at the moment by upwards of 1.5 million barrels of oil per day. While that might sound like a lot, especially given the dramatic drop in oil prices, it's roughly 1.6% of total production. Because it's such a slim margin, Core sees this imbalance as temporary. The reason for this is because of how oil reservoirs work.

Drilling down into the decline rate
An oil well might be the gift that keeps on giving since it can produce oil for decades, but that production doesn't come steadily. Far from it, actually: production initially peaks and then begins a slow and steady decline until the oil field is depleted. That decline rate provides a hurdle to meet current oil demand as well as demand growth. This is why oil companies need to continually drill new wells, as these new wells replace the lost production from legacy wells, while also adding new production to fuel growth.

Core Labs points this out by saying that this decline rate, when combined with demand growth, can easily erase the current oversupply in the market before the end of the year, noting that:

Using a worldwide net annual decline curve rate of 2.5% on current IEA reported production rates approaching 89 MMbopd, coupled with increased demand in response to lower crude prices (US gasoline demand up 10% year-over-year so far in 2015) suggests that markets will balance in late 2015, possibly sooner.

As Core Labs points out, the decline rate from legacy oil production will eat into production rates this year. The reason for this is that we're seeing oil companies rapidly pull back on spending for new wells, and because of this they're not replacing production of depleting wells as quickly as before. When we combine this with stronger demand for gasoline as a result of lower oil prices, we have the recipe for what could be a quick correction to the oil market's over-supply issues.

Core Labs notes that the decline rate from shale wells in particular could yield a quicker correction to the oil market than we've seen in the past because of how rapidly these wells decline when compared to more conventional oil reservoirs. Core Labs pointed out that,

A critical factor in the balancing of markets in late 2015 will come from lower crude oil supply growth from North America, perhaps adding as little as 300,000 bopd in 2015 versus supply growth of over 1,000,000 bopd in both 2014 and 2013. First-year decline curve rates of 60% to 70%, and second-year decline rates of 30% to 40%, in unconventional reservoirs are common.

The company notes that the decline rates of these shale wells can be upwards of 70% in the first year and then another 30% in year two. This means that oil companies need to keep drilling in order to maintain production, as three out of every four barrels of oil added from new wells is needed just to replace the declining production from previously drilled wells. We see this dynamic on the following chart showing production growth in the Eagle Ford Shale.

Source: EIA 

According to the U.S. Energy Information Agency's latest productivity report, it sees roughly 300 drilling rigs running this month in the Eagle Ford, and those rigs will add 158,000 barrels of new daily oil production. However, the decline in oil production from legacy wells of 133,000 barrels of daily production will result in a net gain of just 25,000 barrels of oil added to the daily total. So the rig count wouldn't need to fall all that much before overall production would stop growing, and even decline. Once the market starts to see this begin to happen it could fuel a rally in oil prices, as it would suggest that the oversupply issues are going to begin to fade. 

Investor takeaway
Because of how oil reservoirs work the oil market should naturally correct itself over the next few months now that oil producers are cutting back on investing in new wells. In fact, because shale had been the key to the oversupply, it will be the key to the cutback, as production from these wells declines much faster than conventional oil wells. This suggests that oil prices could rally in the second half of the year as the current glut of oil is quickly worked off.