By Liz Hampton and Devika Krishna Kumar
HOUSTON/NEW YORK (Reuters) - A dreaded scenario for U.S. oil bulls might just be becoming a reality.
Some U.S. shale oil producers, including Oasis Petroleum (OAS.N) and Pioneer Natural Resources Co (PXD.N), are activating drilled but uncompleted wells (DUCs) in a reversal in strategy that threatens to bring more crude to a saturated market and dampen any sustained rebound in prices.
When oil prices started their long slide in mid-2014, many producers kept drilling wells, but halted expensive fracking work that brings them online, waiting for prices to bounce back.
But now, with crude futures hovering near multi-year lows and many doubting recent modest gains that brought oil prices near $40 (27.7 pounds) a barrel (CLc1) can hold, the backlog of DUCs is already shrinking in some areas. In key shale areas such as Eagle Ford or Wolfcamp and Bone Spring in Texas such backlog has fallen by as much as a third over the past six months, according to data compiled by Alex Beeker, a researcher at Wood Mackenzie.
"If the number of DUCs brought online is surprising to the upside, that means U.S. production won't decline as quickly as people expect," said Michael Wittner, global head of oil research at Societe Generale. "More output is bearish.”
In the Wolfcamp, Bone Spring and Eagle Ford, the combined backlog of excessive wells remains around 600, Beeker estimates.
About 660 wells could be the equivalent of between 100,000 and 300,000 barrels per day of potential new supply, according to Ed Longanecker, president of Texas Independent Producers and Royalty Owners Association (TIPRO).
For now, most of the wells are activated in Texas, where proximity to refiners allows producers to sell their crude closer to benchmark prices, and by well-hedged companies that have locked in higher prices.
Still, the pace of fracking of the uncompleted wells may quicken if cash-strapped producers facing debt repayments can no longer afford to store their oil in the ground.
While the potential additional supply is a fraction of total U.S. production of around 9 million bpd, the fresh flow would reinforce concerns about a growing global glut just as Iran ramps up output and inventories in domestic storage tanks from the Gulf to Cushing, Oklahoma, test new highs on a weekly basis.
Wood Mackenzie reckons that the backlog of excess DUCs will decline over the next two years, and return to normal levels by the end of 2017. It is expected to fall 35 percent from current levels in the Bakken and 85 percent in the Eagle Ford by the end of 2016. (Graphic:http://tmsnrt.rs/1PgAf4i)
With service costs down, now is a good time to bring a well online if a company has hedged its production and covered its costs, said Jonathan Garrett, an analyst with Wood Mackenzie. The U.S. crude breakeven for such wells is one-third lower than for new ones, according to Wood Mackenzie.
Typically, average DUC inventory is around 550 in the Wolfcamp/Bone Spring formations and around 300 in the Eagle Ford, Beeker estimates.
In each of those formations, the excess has fallen by about 150-175 over the past six months, bringing the surplus to around 300 wells in each.
"We're just going to be continuously completing the wells there (in the Permian) with our fleets and so you will not see any DUCs in Midland basin," Pioneer Chief Operating Officer, Tim Dove, told a recent earnings conference.
Rival Oasis is also focussing on drawing down its backlog this year, executives said during the company's last earnings call.
Both companies have locked in future sales at prices well above current levels. Oasis has 70 percent of its oil production for 2016 hedged above $50 a barrel and roughly 20 percent of its 2017 production hedged at about $47 a barrel.
Similarly, Pioneer has locked in a minimum price for 85 percent of this year's production.
Not everyone can do it.
In North Dakota, the second-largest oil-producing state where producers like Whiting Petroleum Corp (WLL.N) sell their oil at steep discounts, it might not be economic.
There, the number of DUCs climbed above 1,000 in September before falling to 945 in December, according to the latest data from the state's energy regulator.
Bakken producer Continental Resources Inc (CLR.N), which made waves when it unwound its hedges in late 2014, has said it would continue to defer completions until prices rise.
Bakken discounts were just too steep, said Garrison Allen, a research associate at Raymond James.
"It doesn't make sense to do anything up there."
(Reporting by Liz Hampton in Houston and Devika Krishna Kumar in New York; Editing by Josephine Mason and Tomasz Janowski)