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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Analysts See 2016 Oil Price Rise, While Traders Bet On Fall

Analysts See 2016 Oil Price Rise, While Traders Bet On Fall

Investors trying to decide how to approach the oil markets in 2016 have a fundamental conundrum to deal with, and that is whose views they should trust. This question pits two major camps on Wall Street against one another; analysts and traders.

On the one hand, analysts are of the view that oil production will fall late in 2016 as a sizeable number of drillers face hard times and end up collapsing under the weight of debt obligations. Those that continue to survive will cut back E&P so much that production will fall dramatically as the lack of new supply combines with the sharp decline in production associated with shale wells.

On the other hand, traders are betting on a more malleable supply side of the market. Many see oil companies cutting every cost that isn’t already spent and pumping every drop of oil they can at any price they can get as a mechanism to service debt obligations. Traders then are betting that the oil glut will be slower to evaporate and prices will stay lower for longer. Related: Saudi Air Strikes on Yemeni Oil Port; ISIS Attacks Libyan Oil Port

Both sides make good points. Traders have been right so far, but that does not mean they will continue to be correct. For one thing, at current prices, many oil companies are probably starting to reach the point where their marginal cost of production is higher than the prevailing price in the market. If this is the case, then many of these firms should choose to shut down soon rather than keep pumping and losing money on every barrel.

More importantly, with the Fed starting to raise rates and equity markets crumbling, many firms are going to find their supply of credit all but exhausted regardless of how much oil they are producing. Firms often cite their average debt maturity for their whole portfolio as evidence they have staying power lasting years from now. Yet the reality is that with prices as low as they are, most firms have no free cash to spare, and even a very small debt maturity could be enough to force a restructuring if credit is completely unavailable. In that sense then, analysts should be correct in the end – there is going to be a bloodbath among the oil fields. Related: Seven Years Of Distortion By The Fed Are About To Take Their Toll

The view of traders that oil companies are very resilient also valid though. The oil industry carries substantial amounts of sunk costs, but once these costs are incurred, the cost of extracting oil is quite low. And that price is likely to be lower per barrel on average as a firm pumps more and more. Thus firms have a significant incentive to pump as much as they can. Further, oil companies have already proven very resourceful at wringing savings out of their supply chains and their own cost structures. Related: 10 Reasons why Sub $30 Oil Is A Major Problem

Finally, oil company executives have a personal incentive to keep pumping oil as long as they can – their jobs depend on it. Even if an oil firm is losing money, as long as there is enough cash to keep paying executive salaries, firms which are run by executives may keep operating. This is especially true in the current market – after all, an oil company executive who ran his last firm into bankruptcy and is looking for a new job is probably not going to be a hot commodity at present.

In the short-run then, traders will probably prove prescient again as oil companies adapt and look for ways to minimize losses or even breakeven at current prices. Over the long-run though no one is going to extend credit to oil companies in the current price environment, which should give analysts the last laugh.

By Michael McDonald Of Oilprice.com

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