By A. Gary Shilling:JUNE 28, 2016 12:00 PM EDT
Back in February 2015, the price of West Texas Intermediate stood at about $52 per barrel, half of its 2014 peak. I argued then that a renewed decline was coming that could drive it below $20, a scenario regarded by oil bulls as unthinkable. But prices did fall further, dropping all the way to a low of $26 in February. Since then, crude rallied to spend several weeks flirting with $50 per barrel, a level not seen since last year. But it won’t last; I’m sticking to my call for prices to decline anew to $10 to $20 per barrel.
Recent gains have little to do with the fundamentals that led to the collapse in the first place. Wildfires in the oil-sands region in Canada, output cuts in Nigeria and Venezuela due to political unrest, and hopes that American hydraulic fracturing would run out of steam are the primary causes of the recent spurt.
But the world continues to be awash in crude, and American frackers have replaced the Organization of Petroleum Exporting Countries as the world’s swing producers. The once-feared oil cartel is, to my mind, pretty much finished as an effective price enforcer. Even OPEC’s leader, Saudi Arabia, is acknowledging the new reality by quashing recent attempts to freeze output, borrowing from banks and preparing to sell a stake in its Aramco oil company as it tries to find new sources of non-oil revenue.
The Saudis and their Persian Gulf allies continue to play a desperate game of chicken with other major oil producers. Cartels exist to keep prices above equilibrium, which encourages cheating as cartel members exceed their allotted output and other producers take advantage of inflated prices. So the role of the cartel leader, in this case Saudi Arabia, is to cut its own output, neutralizing the cheaters to keep prices up. But the Saudis suffered market-share losses from their previous production cuts. OPEC has effectively abandoned restraints, with total output soaring to as high as 33 million barrels per day at the end of last year:
Iran, freed of Western sanctions, plans to double output to 6 million barrels a day by 2020, which would make it the second-largest OPEC producer behind Saudi Arabia. Russia continues pumping to support its economy after the collapse in oil prices devastated government revenue and export earnings. War-torn Libya is also ramping up production as best it can.
The International Energy Agency predicts that even with a successful OPEC production freeze, if U.S. frackers cut production by 600,000 barrels a day this year and a further 200,000 barrels per day in 2017, excess supply would run at 1.5 million barrels a day until 2017. That’s a continuation of the recent oversupply of 1 to 2 million barrels a day.
The price at which major producers chicken out and slash production isn’t determined by the prices needed to balance the budgets of oil producing nations, which are as high as $208 per barrel in Libya and as low as $52 per barrel in Kuwait. Nor is it the “full cycle” or average cost of production that includes drilling costs, overheads, pipelines, etc.
In a price war, the chicken-out point is the price that equals the marginal cost of producing oil from an established well. Once fracking operations are set up and staffed, leases paid for, drilling underway and pipelines laid, the marginal cost of shale oil for efficient producers in the Permian Basin in Texas is about $10 to $20 per barrel and even lower in the Persian Gulf.
Furthermore, fracking costs continue to fall as productivity improves. The number of drilling rigs operating in the U.S. continues to drop. But the rigs taken offline are mostly old vertical drillers that drill only one hole per platform, while horizontal rigs — able to drill 20 to 30 wells per platform like the spokes of a wheel — increasingly dominate. So output per working rig is accelerating.
At the same time, global economic growth, and therefore demand for oil, is weak. China, that giant consumer of oil and other commodities, is shifting to services from manufacturing and infrastructure spending. Energy conservation measures in the West are curbing oil demand. And technological advances in fracking, horizontal drilling, deep-water and Arctic drilling will boost non-OPEC supplies to as high as 58.6 million barrels per day this year from 58.1 million in 2015.
And don’t forget the crucial influence of inventories on prices. After all, with global output exceeding demand, the extra crude goes into storage. And when the storage facilities are full, the surplus will be dumped on the market to the detriment of prices. Cushing, Oklahoma, the delivery point for determining the price of West Texas Intermediate, is nearing full storage capacity; the same is true for the Amsterdam-Rotterdam-Antwerp region, the oil gateway to Europe. China is running out of capacity for commercial and strategic reserves. Globally, crude oil inventories have jumped to record levels, with a leap of 370 million barrels since January 2014.
Surplus oil is also being stored on ships, even though so-called floating storage costs $1.13 per barrel per month compared with 40 cents in Cushing and 25 cents per month in underground salt caverns, like those used for the U.S. Strategic Petroleum Reserve. Furthermore, as low oil prices have made shipping by train unprofitable, rail tank cars are being utilized, with so-called rolling storage costing about 50 cents per barrel per month.
So what will trigger renewed price declines? Excess production will end up being dumped onto the market. Pressure from lenders on financially-weak energy borrowers will force them to produce as much oil and gas as possible to service their debts. The likely continuing rise of the safe-haven dollar against the currencies of developing economies will hype the cost of imported oil — universally priced in the U.S. currency — further curbing demand. Finally, the likely slowing of global economic growth and oil demand in reaction to the U.K. decision to leave the European Union reinforces my pessimism.
An oil price drop to below $20 per barrel would be a shock reminiscent of the dotcom collapse in the late 1990s and the subprime mortgage debacle that produced the 2008 financial crisis — both of which triggered recessions. Of course, oil prices would not stay in the $10 to $20 barrel range indefinitely; recession would squeeze out excess energy production and prices would recover, likely to the average cost of new production. But the deflation that might accompany a worldwide economic downturn might mean the new equilibrium price for oil is between $40 and $50 a barrel — well below the $82 average in the first half of this decade, and lower than the assumptions in the business plans of energy producers.
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A Gary Shilling at insight@agaryshilling.com
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Mark Gilbert at magilbert@bloomberg.net