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As the price of West Texas Intermediate (WTI) retests the $40 per barrel (bbl) mark, some pundits are again calling for WTI to fall to $15 or $20/bbl. The same thing happened earlier in the year when crude prices tested $40. Lots of people predicted $20, the price went to $60, and the $20 crowd went quiet for a while. Well, they are back:
“There is no evidence whatsoever to suggest we have bottomed. You could have $15 or $20 oil — easily,” influential money manager David Kotok told CNNMoney. “I’m an old goat. I remember when oil was $3 a barrel,” said Kotok, whose clients include former New Jersey Governor Thomas Kean.
Yes, and you could get a candy bar and soda for a nickel. But I will bet him $10,000 we don’t see WTI at $15/bbl unless he has access to a time machine. Today I want to address this argument. I got into a debate on this topic with a person yesterday, and I am seeing enough of these predictions that I thought it warranted addressing. Again. The $20/bbl argument goes something like this: Crude oil inventories are extremely high. U.S. oil production keeps rising. Demand is falling. Something has to give.
Crude Inventories Did Rise
The problem is that this conventional wisdom argument is wrong on 2 counts. It is true that crude oil inventories are high. Last week there was a surprise build in U.S. crude oil inventories. Analysts were expecting inventories to fall — which they have been doing since April — but instead crude inventories rose by 2.6 million barrels. Following this week’s release of the Weekly Petroleum Status Report announcing the surprise build in inventories, I saw more than one person claim “We are definitely going below $40/bbl today.”
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Didn’t happen. Now it could happen within the next few days. We are close, so one really bad day could drop us below $40, disproving my January prediction that WTI would not close below $40/bbl in 2015. But the price won’t stay there because that is well below the marginal cost of production at the current level of world demand. More on that below.
I don’t believe the people predicting $20 oil are seeing the whole picture. The person I debated this week essentially argued “High inventories = much lower oil prices.” But you have to dig down a bit more than that. Why did inventories rise last week? There were two primary drivers.
The first is that the BP refinery in Whiting, Indiana — one of the largest in the country — is dealing with unexpected maintenance problems. They have 235,000 barrels per day (bpd) of crude oil refining capacity offline. (For those who think this is some sort of conspiracy by BP to drive up gasoline prices, get real. This helps all the other refiners — not BP). So BP didn’t consume about 1.6 million barrels of crude during the week that they otherwise would have consumed. Yet inventories rose even more than that. Why? Did U.S. production surge?
U.S. Crude Production is Falling
No, U.S. crude oil production is now falling. The Energy Information Administration (EIA) reported in its most recent Short Term Energy Outlook (STEO) that U.S. crude oil production declined by 100,000 bpd in July compared with June, and they expect these declines to continue because of the steep cuts shale oil producers have made to their budgets. The EIA reduced its forecast for oil production next year to 400,000 bpd less than this year. More on the significance of this below.
So why did inventories increase last week? It was actually because crude oil imports surged. Crude oil imports were 465,000 bpd higher than the previous week. That means 3.3 million barrels more oil came into the country than arrived in the previous week. Add that to the BP outage, and there was a surplus of oil of 4.9 million barrels relative to the previous week. This more than explains the 2.6 million barrel weekly gain in inventories. The question is “Will that continue to happen?”
In my opinion, “No.” The BP outage will continue for an indefinite period, but the import surge was an anomaly. Crude imports from Canada surged by 404,000 bpd from the previous week. But guess what? Canadian oil producers are in an even deeper bind than U.S. oil producers. A recent article stated that at $40/bbl WTI, Canada’s largest synthetic crude project is losing about $10 on every barrel. How long do you suppose that can continue? The larger producers will hang in as long as they can, but some of the smaller guys are going to be shutting in production at $40 WTI (which implies an even lower price for them due to the distance to market). That will reduce imports from Canada — the very imports that surprisingly drove crude inventories higher this week.
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The U.S. Role in the Global Supply Picture
U.S. crude oil production is falling because investments into shale oil production dried up as the price of crude oil fell below $60/bbl. Companies aren’t interested in putting new capital to work, and because these oil fields deplete, that means crude production is falling. Why is that significant? Because most of the world’s new oil production in the past 6 years has come from U.S. shale oil fields. It is hard to overstate the global importance of the new crude supply that came online in the U.S. since 2008. Perhaps this graphic will help put it into perspective:
(Click to enlarge)
Since 2008, U.S. oil production growth is equivalent to 83% of the global supply added during that time. (Some countries had declines in oil production, which is why the increases shown on the chart add up to more than the global total.) Not only did U.S. oil production grow faster than production in Saudi Arabia and Russia, but it outpaced production growth in all of OPEC, as well as the entire Middle East. Yet even with U.S. shale oil production, oil prices exceeded $100/bbl. And while U.S. shale oil producers have been getting more efficient, they aren’t going to invest in new production at current prices. Hence, the handwriting is on the wall. (For an explanation of BP’s crude oil accounting, see Is the U.S. Really the World’s Top Oil Producer?).
But what about demand? Isn’t it declining? No. Our Western-centric view of the world may give us the impression that oil demand is declining, but the truth is quite different:
(Click to enlarge)
Over just the past decade global oil consumption increased by an average of 900,000 bpd each year, and consumption has risen in 18 of the past 20 years. If we look back 30 years, global oil consumption increased by an average of 1.1 million bpd annually. Demand did decline in member countries of the Organisation for Economic Co-operation and Development (OECD) — the grouping of the world’s developed countries. But demand growth in developing countries overwhelmed the declines in the developed world. In just the past five years, demand in developing countries has increased by an average of 1.6 million bpd annually, and now exceeds OECD demand.
(Click to enlarge)
Note that there was hardly any negative impact on demand in developing countries even with oil prices at $100/bbl. What drives consumption in these countries is a very large number of people using just a little bit more oil than they did before. High oil prices will do little to dissuade them from buying a little bit more when it can make such a big impact on their lives, especially when incomes are rising.
Global demand growth for crude oil is projected to continue. The International Energy Agency recently forecast that global demand will increase by 1.4 million barrels per day this year, and a further 1.2 million bpd in 2016. The bulk of that demand growth is expected to come from developing countries in Asia. With U.S. supply falling, where are the new oil supplies coming from to satisfy global demand at $40/bbl oil? There simply isn’t enough to go around. Another way of looking at this is “We are past peak $40/bbl oil.”
Iran Can’t Close the Gap
Yes, Iran may be putting another half million barrels per day on the export market over the next year. However, oil production in Iran has historically grown slowly. In the past 20 years the most they ever increased production by in a single year was 423,000 bpd. The 2nd most was 249,000 bpd. I am a bit skeptical about some of the optimistic forecasts for their ramp up. A year from now Iran’s half million barrels per day may be on the market, but then oil demand will be another 1.4 million bpd higher.
Further, if U.S. production begins to decline in earnest, that production will have to be made up as well. So if the IEA is correct we need another 1.4 million bpd plus the losses that will happen as a result of lower oil prices — and if Iran is stepping up then it will be taking place in an unstable region of the world. Is this really a scenario that can support $40 oil?
This is why, in my opinion, oil can’t go to $20/bbl. Despite very vocal predictions of much lower oil prices, many people are aware of the dynamics I have laid out here. They know that if you look at this moment in time, today, the market is slightly oversupplied. That is why oil prices are in the $40′s. But 6 months or a year from now? No way. Demand will keep growing, and there aren’t enough producers willing to grow oil production at these prices. Thus, prices will rise, so every time WTI gets down to the sort of unsustainable level it is at now buyers start stepping up.
The OPEC Wild Card
This scenario presumes that OPEC doesn’t blink. If you recall, at OPEC’s meeting in late November 2014, they decided to defend market share instead of reducing production quotas, as some expected, to prop up the price of crude. OPEC’s rationale was that such a move would only help shale oil producers grow their market share by allowing them to maintain high margins. Instead OPEC decided to produce all out, and the falling oil prices that began in the summer accelerated following OPEC’s meeting. (See OPEC Crashed the U.S. Rig Count for additional background).
At their June 5th meeting this year, they once more decided to leave production unchanged. But this strategy is inflicting a lot of pain on OPEC countries, and many are becoming more vocal about the issue. This week Algeria wrote a letter to OPEC questioning the wisdom of their current strategy. The letter asked OPEC to consider taking some form of action to bolster oil prices, as many OPEC countries need oil prices to be at least $100/bbl to balance their budgets. CNN recently reported that this year Saudi Arabia alone has burned through $62 billion of its cash reserves. By my calculations, the steep slide in the price of oil has cost Saudi Arabia around $200 billion in the past year.
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Personally, I think Saudi made a monumental miscalculation. While I have seen some claim that the rise of shale oil has effectively neutered OPEC, keep in mind that the organization still produced 41% of the world’s oil last year. 36.6 million bpd of global production came from OPEC. Had they decided to cut production by 5% or so last fall, they would have lost some market share, and yes, the shale oil producers would have kept growing production. But oil prices would probably be at least twice what they are now. The net outcome for OPEC, despite the loss of market share, would have been much higher revenues than what they ended up with.
Another problem for Saudi Arabia now is one of saving face. If they announce an emergency cut to the quotas, or even announce this at their next meeting in December, they will be admitting defeat. They may argue that if they can hold out just a bit longer, they can set the shale oil industry back by years, and then when prices go back up OPEC will be the biggest beneficiary. That is not the decision I would make, but certainly a decision that has benefited U.S. consumers.
I don’t like predicting prices short term, because they are less influenced by fundamental factors. Longer term, irrational markets return to pricing based on fundamental factors like the cost to produce something and make a profit. In the long run, $40/bbl oil is not a price sufficient to entice enough oil producers to produce at a level that can satisfy global demand. Hence, prices will rise. How long will it take? Hard to say. Oil prices stayed above $100/bbl for a lot longer than I thought they would. Maybe they will remain depressed longer than I think they will. Personally, I believe prices will be back up to the $60/bbl level in 6 months or a year – and that’s without any action from OPEC. If OPEC announced a 10% across the board production cut, that’s a Black Swan that would drive prices back to $100/bbl very quickly.
Here is a closing thought. If you could freeze the price of oil at $40/bbl for the next year, what do you think would happen? Supply would be lower in a year, and demand would be higher. In the real world, the price of oil will rise. Granted, the oil markets are notorious for over-correcting, which is the situation they are in right now, in my opinion. Could the price of oil drop to $20/bbl briefly? Well, these are predictions and opinions, and I am on the record predicting that WTI would not close below $40/bbl this year, but you never say never. I think it’s highly unlikely though. If WTI shocks me and does fall to $20/bbl I will scrape together every penny I can and buy oil, and just sit back and wait for the inevitable swing in the other direction.
By Robert Rapier
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