As the price of oil starts its second dramatic act of the year, collapsing after a short-lived rebound in the Spring, many investors are undoubtedly hoping that the price will start to rise again later this year.
Those hopes may be misplaced as Texas looks set to produce a record level of output this year, toppling a production record that has stood for more than thirty years. And Texas is not alone on that front. Around the world, many countries are reporting continuing or increasing production. OPEC looks to have pumped more oil in July than in June despite the fall in prices. And in the medium term, Iran's production will exacerbate the situation.
The fundamental problem with the oil markets here is one of incentives. Oil wells require extensive up-front costs. Once those costs are spent though, the price of pumping out the oil itself is relatively low. As a result, with these sunk costs already invested, companies around the world from Saudi Arabia to North Dakota have no individual incentive to lower production. Related: EIA Capitulates Under Cover Of Darkness
A single company in North Dakota for example, cannot raise the price of oil on its own by cutting production. As a result, the company instead wants to maximize production from its existing wells. It may not be economical to drill new wells, but the company might as well get full value from its existing set.
Even worse for price though, firms have an incentive to produce now rather than waiting.
Previously, some firms likely hoped that oil prices would spring back by the end of 2015 and that the firm's hedges could keep sales receipts high enough to avoid dealing with the dramatic fall in prices.
But prices have not bounced back, and with most market participants now resigned to at least another year of low oil prices, a lot of hope has gone out of the markets. Related: Recession Risk Mounting For Canada
Moreover, summer driving season is starting to wind down, and with it, demand for oil will start to dwindle. As a result, it's quite likely that prices in the low $40s or even high $30s will be seen by the end of the year. Faced with a classic deflationary price spiral, companies want to maximize their per barrel revenue and that means pumping as much as possible as fast as possible and selling now before prices fall more.
There are only two ways to fix this type of deflationary price spiral in economics: consolidation of the industry leading to monopoly or oligopoly power, or the exit of firms from the market.
OPEC was able to keep prices from collapsing like this for decades because the block of producers acted as a monopoly. As long as most significant producers were inside the cartel or went along with its production levels, prices could remain stable. The arrival of non-traditional producers like oil sands firms and shale oil firms upended that model. Now, the Cartel cannot exert the same level of influence on production levels, so even OPEC members have little incentive to do anything other than pump as much as they can. Related: China Getting Serious About Solar Energy
The other solution to the current oil price environment is a wide-spread exodus from the industry. In practice, this means a combination of bankruptcy, and not drilling new wells. The EIA is showing a record level of excess production over demand, and that production gap has to be corrected by firms deciding it is not in their best interest to drill new wells.
This will take time though. First, many firms were propped up by their hedging programs. Those hedges are only just now starting to expire and exposing firms to the full depth of the oil price drop. Second, firms will keep pumping in many cases until their wells run dry. Fortunately for oil investors, shale wells have a much faster decline rate than traditional wells. Shale wells decline at a rate of between 60 percent and 90 percent over the course of three years.
Rapid decline rates mean that U.S. oil production could begin declining as fewer and fewer new wells are drilled. But it will take time for production to come down sufficiently enough to support a major oil price rebound. Given that, investors need to focus on oil stocks that can get through the next two years on minimal (if any) profit, and they themselves need to be prepared to wait for a price rebound until 2017.
By Michael McDonald for Oilprice.com
More Top Reads From Oilprice.com:
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… More
Comments
The author Michael seems to promote the idea that oil producers have to pump more to drive down the price and eventually kill themselves. Are human being that irrational?
I would tend to believe the conclusion is not quites as good as leonard brecken.
Try this one:
Top 6 Myths Driving Oil Prices Down
Yesterday's ending price is instructive, in fact the first trading day of the month has been quite so all year. The SEC pv10 valuations are going to take about a 30 percent hit from end first to end third Q 2015.
The author of the smoke and mirrors has some good points, unless their is a quick snap back in prices, we are likely to see bankers pull the plug on liquidity for many of the small to mid sized players that represent a lot of US drilling in agregate.
Combined with exaggerated supply numbers from the EIA we could see domestic production fall much quicker. We also don't know how much more the saudis can produce. Nobody wants to mention that price has created 1-2 million barrels in extra demand per day this year and that matches up with the extra supply from aramco and Iraq.
If production declines approx. 100,000 B/D per month May through Dec, the US will be down 600,000 to 700,000 B/D or more by year end. With over a 1000 rigs down (60% from the peak of Oct 2014), this seems reasonable with fracklog completions falling but masking the natural decline of shale oil in the first half of 2015.. I would expect with the 2015, rig count (forget the nominal increase or decreases as this point) that production will decline further in 2016 given that the fracklog ihas been completing many wells drilled in 2014.
There are many alternative energy sources and alternative chemicals coming on line. Oil is no longer the only game in town. So many companies have been continually screwed by big oil and are no longer willing to play oils game. Oil is not on the way out, but is on the way down. The alternatives have come to far to suddenly turn back, there are billions if not trillions invested in alternative energies and materials.
Big oil and it's greed is its own enemy, screw people and companies long enough and they will run you over.
Watching big oil and it's execs squirm is very, very satisfying.
Now regardless of the promo spin by shale oil producers (and their investment/banks): a 50% drop in the price of oil does not equate to a 50% drop in costs, increased efficiency, developing the "sweet spots" etc., to arrive at a "new" break-even ($60/B is the "new" $90/B); price is a multiplier, cost is a line item. Then there's the breathtaking decline rate; your on a capital monster treadmill requiring exponentially increasing drilling, (rigs).
I'm for all alternative energy sources; it's just they're so damn costly.
Furthermore, alternative energies such as solar and wind will ever only be additive and marginal sources, as their intermittency and high cost make them unable to compete. Besides, solar and wind don't compete directly with oil, as we don't use oil to generate electricity.
The author of this article failed to mention the $300 billion capex reduction globally, and the fact that the global production decline rate is about 4%, not counting the higher decline rate for shale. This leads to the conclusion that the supply/demand balance should start to appear by mid-2016.
Furthermore, alternative energies such as solar and wind will ever only be additive and marginal sources, as their intermittency and high cost make them unable to compete. Besides, solar and wind don't compete directly with oil, as we don't use oil to generate electricity.
The author of this article failed to mention the $300 billion capex reduction globally, and the fact that the global production decline rate is about 4%, not counting the higher decline rate for shale. This leads to the conclusion that the supply/demand balance should start to appear by mid-2016.
At the beginning of the Viet Nam war I was drafted into the US Army (1965) as a Pvt E-0. I went on to serve as an NCO and Infantry Officer. On returning to the US, I finished my education graduating with several degrees including Petroleum Engineering and went on to work in the industry with major oil companies and later in the Energy Division of a NY money center bank. Then in the mid 1980's founded an oil & gas consulting company that served the industry, investors and banks. Later others and I acquired several service company's and then we founded an independent oil company that has survived at lease six down cycles. In the 1990's I was elected to the Board of the NRA; hardly a Marxist organization.
My comments are based on my 46 years of industry experience and are offered for consideration by those who may be investing. I provide no political advice and have no agenda.
I don't know if your comments come from your ignorance or stupidity, but in either case you are clueless.