Investors can be forgiven if they are more puzzled than ever regarding the trajectory of oil prices. The gyrations over the past month have induced a sense of deep despair, followed by a brief period of optimism, only for those hopes to be quickly dashed. With oil edging back up towards $50 again, there are likely fewer people than last month who are willing to buy into the notion that the rally is for real.
A dose of skepticism, in this market, is healthy. Some analysts predict prices will plunge well below $40 while others see them steadily rising to $60 or $70, but there is a much greater probability that oil stays stuck in its current range.
The extraordinarily rapid rise of U.S. shale production sputtered in June, even as the industry still appears to be expanding. The EIA reported one week’s worth of production declines, while the rig count contracted a bit before rebounding again. The data could be noise…but it could also be a sign that some of the weaker shale players are beginning to struggle with oil prices at $45 and below.
“If oil holds under $45, that would make a difference to us,” James Mayer, CEO of Green Century Resources, a small Texas shale driller, told the Houston Chronicle. Green Century might cancel or delay drilling plans if oil prices remain in the mid-$40s or below.
The same could be true for dozens of other companies. That means that if oil prices stay in the mid-$40s, or fall even lower, U.S. shale could run up against some limits. Drillers start to feel pressure, balance sheets get stretched, and ultimately, drilling needs to be curtailed. The degree to which shale throttles back when prices drop will be key to oil prices for the rest of the year and into 2018. The flip side is that if oil moves back to $50 or above, U.S. shale will likely grow at an unbridled rate, which will then once again put pressure on prices.
The most likely scenario, then, is that oil prices are stuck within a range for $45 to $55, with little chance of breaking out. Any decline in price will test U.S. shale, while any increase will bring shale back. The result is a self-correcting phenomenon that leaves oil stuck.
Goldman Sachs highlighted this situation earlier this week, noting that the oil market has actually become a highly competitive market, which is to say, one with “razor thin margins” and low volatility.
Oil prices below $50 per barrel mean shale companies don’t offer much return, with many E&Ps returning $0.80 for every $1 invested, according to Goldman Sachs. So why are shale companies refusing to turn off the taps despite such disappointing returns?
The problem up until now is that Wall Street has been too generous, keeping the industry going full-tilt even when there is little prospect of higher oil prices.
"There's not too much oil in this market, there's too much money in this market," said Jeff Currie, global head of commodities research at Goldman Sachs. Oil prices remain depressed because so much money is going into new drilling, leading to a glut in supply.
Even when companies are struggling, a new wave of capital floods into the sector to keep the drilling going. Instead of letting indebted companies close up shop, they are recapitalized and sent back into the field. The end result is more production, lower breakeven prices, and a stagnant price for crude – a dynamic that is befuddling OPEC.
Of course, lower oil prices would theoretically push shale drillers out of the market, force consolidation, and lead to a faster rebalancing and eventually a higher oil price. But Goldman doesn’t actually see much chance of a sharply lower oil price, to below $40 per barrel, for example.
Prior plunges into the $30s and even into the $20s were the result of a lot of storage capacity maxing out. But, these days, there is plenty of storage capacity – some new facilities have come online, and some drawdowns have freed up space – so if drillers ramp up production, those extra barrels can easily find a home somewhere. The end result is that there is little chance of panicked selling that would push oil below $40 for very long.
“Unfortunately, the ability of this market to roll over inventory, I think, is quite high. Which means, you’re probably stuck in a relatively tight range,” Goldman’s Jeff Currie said.
Currie said he would like to see oil really plunge because that is what would be needed to help rebalance the market, but the odds of that actually happening are really low.
Without that plunge, the pace of inventory declines could remain rather modest. The IEA predicted that inventories would decline at a pace of 0.7 million barrels per day in the second quarter, a pace that would accelerate as the year wore on. However, in their latest Oil Market Report, they admitted that such a rate of drawdowns might not actually be happening.
Goldman is more skeptical, predicting a rather paltry decline of 0.3 mb/d for 2017, which will narrow to an even small decline of 0.1 mb/d in 2018. So far, they seem closer to the mark.
But while oil prices might not fall very far, modest inventory declines are not a recipe for higher oil prices either.
(Click to enlarge)