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Only An OPEC Miracle Can Save Venezuela

Venezuela’s oil minister Del Pino…

An Oil Price Spike Could Be Nearer Than You Think

An Oil Price Spike Could Be Nearer Than You Think

Market fundamentalists tell us that prices convey information. Yet, while our barbers and hairdressers might be able to give us an extended account of why their prices have changed in the last few years, commodities such as oil--which reached a six-year low last week--stand mute. To fill that silence, many people are only too eager to speak for oil. And, they have been speaking volumes. So much information in that one price!

First, as prices fell last year when OPEC refused to cut its oil production in the face of slowing world demand, the industry kept saying that it could continue to produce from American tight oil fields at around $80 a barrel and be profitable. Then, as prices fell further, the industry and its consultants assured everyone that while growth in tight oil production would slow, it would still be profitable for the vast majority of wells planned.

Petroleum geologist and consultant Art Berman is probably the best representative from the skeptical camp. For many years Berman has been pointing to the high cost of getting fracked oil out of the ground. And, those costs led to negative free cash flow for most tight oil operators for several years in a row--that is, they spent considerably more cash than they took in, making up the balance with debt and stock issuance. Not surprisingly, the operators took that money and kept drilling as fast as they could.

It was a recipe for oversupply and a crash, one that is now threatening the solvency of many fracking-dependent U.S. oil companies.

As if to the rescue, the giant consulting firm Deloitte called a bottom in the oil price when U.S. futures prices hit $48 a barrel on February 4--a little prematurely it seems. Friday's price for September futures on the NYMEX closed at $42.50. Related: Could This Be The Next Great Renewable Energy Source?

Not to worry. Two major international oil companies, Chevron and Exxon, declared back in December that $40-a-barrel oil won't be a problem for them. One of the sources cited was Exxon CEO Rex Tillerson whose company has had trouble replacing its oil reserves for more than a decade at much higher average prices. In fact, oil majors have been cutting exploration budgets since early 2014 when oil prices were still hovering above $100.

It seemed as if the message that the price of oil was sending from about the middle of last year until just recently was going unheeded by American oil producers. U.S. oil production kept rising despite dramatically falling prices. But when production growth finally stopped in June, there was hope that less supply would be weighing on prices, and predictions abounded that the price would go higher.

The reasoning behind this call was that continuing economic growth worldwide would combine with stagnating growth in oil supplies to squeeze the market enough to move prices up.

While low oil prices were supposed to "spur the global economy" according to the International Monetary Fund, The Economist magazine took a more measured view. It also looked at the decline in employment and investment in oil which had previously been booming.

High-cost oil from the Canadian tar sands is also taking a significant hit as investment is slashed in the face of low prices.

With the recent renewed slump in oil prices, the industry is trotting out the same kind of stories it trotted out when oil was around $80 and then $60. Oil at $30 a barrel will be no problem for a special breed of drillers in the Bakken Formation of North Dakota, we are told. If you actually read the story, it is stating the obvious: That break-even prices vary from well to well. And, the writer refers to "realized" prices, not the NYMEX futures price. It turns out that because Bakken lacks pipelines for transporting oil, it must use oil trains. That's expensive. Related: Unorthodox Plays For The Savvy Energy Investor

So, those buying oil from North Dakota take the freight costs into account. The average realized price on Friday $28.75 for the type of oil extracted from Bakken's deep shales in North Dakota. While wells that are already drilled often produce regardless of price because those who operate them must pay back debt, it is doubtful that very many new wells would be profitable at this price. And, it is worth noting those investing their capital do not as a rule seek to break even. A break-even proposition usually sends them looking elsewhere to invest their money.

Beyond this, there is a broader consideration. And, it is something which very few people seem to be talking about when it comes to all the information that is supposed to be conveyed by the oil price.

As the world's central energy commodity, oil is a good indicator of economic activity. With the nearly universal conviction that the previous bounce in oil prices to around $60 signaled a stronger economy and thus stronger oil demand, logic would dictate that we now consider the opposite: That the new slide in oil prices is signaling new weakness in the world economy. If so, it's the kind that ought to frighten even the optimists this time.

Having said all this, it might be wise to take any day's price reports in the same way as the low or high temperatures on a particular day. A cool morning in summer does not mean winter is right around the corner. Nor does a hot day in mid-winter spell the end of the season. What's more important is to look at the overall picture to see if the season is changing--or even more important, if the climate itself has shifted, both literally and metaphorically. Related: The “Thin Green Line” Holding Back U.S. Energy Exports

That takes a lot more analysis than the daily market reports can provide and than most people--even those whose job it is to follow markets--have patience for.

In that regard the long view suggests that the acute investment slump in oil which is unfolding will lead to tight supplies in a few years (because of all the wells that are not going to be drilled to replace the depletion from existing wells). That would set us up for a price spike at some point as it takes a considerable amount of time to ramp up new drilling after a long period of decline.

All this assumes that the current seeming weakness in the economy doesn't morph into something that would cause a long-term economic decline or stagnation which would keep oil prices low for a much longer period.

By Kurt Cobb

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  • gtatar@shaw.ca on August 18 2015 said:
    My guess is that within 2-3 years we are back over $70 oil, once supply and demand dynamics work themselves out.
  • John Brown on August 18 2015 said:
    So low prices at some point will lead to lower production and higher prices? Really? Thanks for the supply and demand 101 lecture. However, right now there is a massive gut of excess oil on the market, and with China is recession and panic mode its hard to see that demand is going to suddenly kick into gear, and even if/when it starts to recover it doesn't kick in overnight. For the rest of this year and into next there is going to be a glut of oil on the market, and no reason why oil won't dip below 40, even to $30 a gallon. Low prices will then reduce supply, demand will pick up sometime we had better hope, and as excess supply is reduced prices will begin to recover with the possibility of a spike, just like right now we should see a drop down. However, the new technology doesn't go away, and it looks like increases in price will spur increases in supply faster than in the past. Its hard to see how we get back to more than $60 oil, minus a short term spike, for years. There are a lot of wishful thinkers out there doing everything they can to hold up and increase the price of oil, but the over supply says we are headed lower, not higher.
  • adam on August 18 2015 said:
    Demand is not going higher till they sort out the fual prices, I no I for one am not driving as much when prices are as high as early last year.
  • Brad on August 22 2015 said:
    Alternative energy is getting crushed. Government subsidies for alternative energy are drying up. Low prices for oil are driving all sorts of traditional energy companies out of the market as well. We have a stellar example of dog-eat-dog capitalism in one of the world's largest capital markets. So to invest well you have to figure out who will win this fight. Sounds obvious but it is hard to do.
  • Amvet on August 23 2015 said:
    There is no oil supply glut. Look at the most recent oil storage surge.

    Storage surge 2.6 million bbls week to week

    BP refinery closed--1.6 million bbls not used for the week
    Import surge--- 3.3million bbls extra for the week.


    A constant supply would have caused a surge of 4.9 million bbls.
    Punch line, supply was down by 2 million bbls for the week.

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