Why The World Is Still Pumping So Much Oil Even As Demand Drops Away

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With the global economy in a pandemic-induced coma, the world just doesn't need a lot of oil.

But oil is still flowing out of wells, and with nowhere else to go, it's filling up the world's storage tanks. The oversupply is so intense that this week U.S. oil prices briefly went negative.

But why is that oil still flowing, anyway? Why don't producers turn off the spigot when demand falls?

The short answer is that production is decreasing — just not fast enough.

"The crude markets move in slow motion," says Bernadette Johnson, the vice president of market intelligence for Enverus. "So what we're seeing is almost a slow-motion train wreck."

Crude in a pipeline can take weeks to reach its destination, which means oil purchased in mid-March could still be in transit in mid-April. This spring, the world completely transformed faster than some oil could finish that trip.

And that's not the only source of delay. When demand plummets and prices drop, it takes time for oil producers to start turning off existing wells. Reducing output like that is known as "shutting in" production.

"Shutting-in production is a very painful decision for an operator to make," Teodora Cowie, an analyst with Rystad Energy, writes. "Often the economics support running a well at a loss for a certain period of time rather than shutting down the project completely."

As long as prices are greater than zero (an unusual disclaimer for these unusual times), a well will still bring in some money. And oil companies have fixed costs they have to cover. Even if they're taking a loss overall, it may be better to keep a well running than to bring in no money.

They're also looking ahead to the future, when demand and prices are eventually expected to rebound. An oil well is not like a light switch you can flick on and off. A well that has been shut down can be hard to turn back on.

Elizabeth Gerbel, CEO of EAG Services, an oil and gas consulting company, compares it to a bottle of soda. If you put the cap back on and store it in the fridge for a while, it will never be as bubbly as when you first cracked it open.

Similarly, if you start pumping from a well, shut it down and try to get it running again, "it is almost guaranteed you will have to invest more money in the well to get it to produce at the same level," she says.

And it's not just the physics of oil fields working against producers here. It's their legal contracts: They may have signed leases that require them to drill the land in question. "If you are forced to shut-in a lot, you technically can lose your lease to a competitor," Gerbel says. "And then you're going to have to buy them back."

So even at very low oil prices — prices where oil producers clearly are unable to make a profit — they might opt to keep wells running now, to ensure they can operate those wells in the future.

Eventually, very low prices make that untenable, and shut-ins do occur. Rystad Energy estimates that nearly 2 million barrels per day have been shut in already, mostly in Canada.

And as the glut grows so intense that tanks, pipelines and ships run out of space, companies may be forced to shut in some wells that they would like to keep running, simply because there is nowhere they can immediately store their oil.

There's another way that oil companies are reducing output: cutting back on new wells.

Drilling a new well is expensive. Last month, the Dallas Fed Energy Survey reported that on average, U.S. firms need oil prices to be at least $49 per barrel to profitably drill a new well. The U.S. benchmark oil price is currently at less than $14 a barrel.

So when prices drop, companies often move quite quickly to reduce drilling — well before they shut in existing production.

The number of active drilling rigs has dropped to less than 440, according to data from Baker Hughes; it was at 825 a year ago.

That means a drop in output, particularly for shale producers, which have to keep drilling new wells just to maintain existing production levels.

But Johnson, of Enverus, notes that new shale wells can also be drilled and brought online unusually quickly. This means that while the shale industry — like the rest of the oil industry — is currently reeling, production could also come back quite quickly if demand returns.