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Major Commodity Trader Sees Looming Oil Price Spikes

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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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Why An Oil Price Crash Remains Unlikely

There has been a lot of optimism returning to the energy markets of late as oil prices have climbed to the $50 a barrel region. Ironically, while a few years ago $50 a barrel would have been seen as an unthinkably low oil price, today it is regarded as much needed relief from prices that ran in the $25 a barrel region earlier this year. Yet with the climb in prices, analysts are now starting to forecast prices per barrel of as much as $80 in the next year. That view is not the mainstream though.

Instead most analysts are looking for oil prices to remain in the $50 range over the next year, and that has some investors forgetting about the possibility of a renewed downside in oil which could create more losses. In particular, noted economist Gary Shilling is out with a much discussed forecast that oil will retrace its losses and fall even further to between $10 and $20 per barrel. No one knows what the future will bring of course, but Shilling’s view is worth considering.

Broadly speaking, Shilling’s thesis has three points of note for investors. First, he points out that Saudi Arabia and more broadly OPEC, have lost any semblance of control that they once exercised over the markets. That’s unequivocally true. OPEC is no longer the swing producer of oil, and internal divisions within the cartel are so great that any kind of coordination among producers looks increasingly unlikely. That in turn makes coordination with outside producers like Russia out of the question. Rationally then, OPEC is likely to continue producing as much as they possible can. The constraint facing many OPEC nations is their ability to invest in new capex rather than internal OPEC dictates. Related: Is Russia Winning The Oil Export War Against The Saudis?

Second, Shilling sees U.S. producers as the new swing producers and says that production will continue as long as the price of oil remains above the marginal cost per barrel in U.S. shale formations. That marginal cost is between $10 and $20 a barrel excluding existing sunk costs like leases and drilling expenses.

Third, Shilling sees renewed global economic weakness from China and Japan to Europe failing to trigger much growth in oil demand. It’s particularly hard to argue with this tenet of the thesis. Global growth has consistently underperformed in recent years and it shows no signs of improving now. The Brexit situation combined with cratering growth rates in China are doing little to bolster confidence. Indeed for all of the concern about the U.S. economy as a whole, the U.S. is arguably the only country doing even reasonably well. Related: Oil Bust Continues To Take Its Toll On Canadian Economy

Yet for all of the negatives around oil, and it is easy to make a bear case, the economics of oil production still leave room for hope. Shilling is right that the U.S. is the key producer on the world stage today. U.S. producers are more volatile and financially weaker than other major producers. As much of a basket case as Iran and Venezuela are, both are far less likely to go bankrupt than most of the individual oil producing companies in the U.S.

The bull case for oil then rests on the frailty of U.S. producers and the speed of the decline curve in horizontally fracked wells. Fracked wells decline much faster in production terms than conventional wells do – about 70 percent of production falls off within two years. Thus shale producers have to keep drilling new wells just to maintain production.

At this stage and at prices below $40 a barrel, virtually no new drilling occurs. As a result, prices today may be artificially boosted by market speculation, but as long as they don’t go high enough to lead to significant new drilling, fundamentals will eventually catch up and production will fall dramatically. That in turn will support current prices and perhaps even higher prices in the future.

By Michael McDonald of Oilprice.com

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