Fallout and future outlook from nosedive in price of oil

The causes cited for the precipitous fall in oil prices recently include technological advancements, abating geopolitical tensions, global economic weakness, and conspiracy theories.  

Over a six- to eight-month period, crude oil prices (West Texas Intermediate) have plummeted by almost 50 percent from a 2014 high exceeding $107 per barrel.  

One of the conspiracy theories floating around suggests a secret plan was devised by the U.S. and Saudi Arabia to significantly torment Russia. Although there is no way to prove or disprove this theory, the available data and traditional characteristics of the energy markets suggest a greater likelihood that supply and demand dynamics are at play here. 

 

Increase in supply   

The U.S. shale oil revolution has been the greatest contributor to the uptick in global oil production over the last three years. Although the U.S. is not an oil exporter, its imports of black gold have diminished significantly, contributing to the rise in spare supply.

While production from the Organization of Petroleum Export Countries (OPEC) has remained flat over the last two years, countries like Iraq and Libya have gradually recommenced production after the turmoil in their countries started easing. Despite Saudi Arabia’s wherewithal to prevent a sliding oil price by curbing production, the largest OPEC producer has decided that such a move would primarily benefit other countries like Russia and Iran. Saudi Arabia has sufficient reserves to ride out a price war and is determined to do so. 

 

Demand prospects have weakened  

While much of the media has focused on the supply side of the equation, there is sufficient evidence that concerns over future demand are equally to blame for the collapse in oil prices. Signs of weakening growth prospects in both China and Europe have sent a strong signal that the price of this commodity may be unsustainable given the projected level of demand.  

 

The winners and losers  

Any dramatic swing in the price of an asset invariably produces winners and losers. While the obvious victors are the stronger members of OPEC, who are desperately seeking to maintain or gain market share, the shipping industry, albeit less obvious, is a benefactor of cheap oil as well.  

One also hopes that the lower oil price will translate into cheaper gas prices, leaving consumers with greater disposable income and more spending power to support economic growth. 

Not surprisingly, there are also some unintended consequences and disadvantages to contend with. Central banks, already struggling to achieve their inflation target, are now confronted with another headwind exerting downward pressure on the consumer price gauge. The most obvious losers are OPEC’s weaker members, including Venezuela and Iran, both of whom desperately need higher prices to survive. 

The largest and fastest growing oil company in the U.S., EOG Resources, is reducing its 2015 spending forecast by 40 percent and drilling by half. Headlines such as these, along with news of energy behemoths BP and Haliburton slashing jobs and reducing capital spending, create uneasiness in the markets. Reports of closing rigs only add to the perception that the oil industry is completely falling apart.

That is not necessarily the case!

While some oil producers have indicated that oil below $70 poses a problem, others claim that they are able to cope as long as prices don’t dip below $50 per barrel.  

With more than 8000 oil companies in the U.S., not all employing the same drilling techniques (vertical vs. horizontal), operating in different locations, and most importantly, with different financial risk strategies in place, one cap does not fit all.  

The ability to continue to produce at current price levels, despite lower margins, is more tenable for those companies that still have price hedges in place, therefore locking in a comfortable profit. So while companies like EOG, without hedges in place are expected to reduce spending, there are other companies that may be able to continue operating at current price levels for as long as their pre-oil crisis hedges have not yet expired.  

Another factor affecting the financial health of exploration and production companies is the amount of debt issued to fund their capital investments. If markets are anticipating weaker earnings, debt markets could dry up, forcing companies to further reduce capital investments.  

It is also worth noting that while the costs of bringing new wells online may be a deterrent at very low crude oil price levels, there is no benefit to curtailing production at existing wells given that initial capital investment is considered a sunk cost. It’s for this reason we have not heard of a significant number of well closures. Instead, the announcements from industry participants are primarily centered on cutting projected capital investments on previously planned projects.  

 

The future of oil  

With the 12-member oil cartel maintaining its production levels and the U.S. Energy Information Administration predicting that U.S. oil production will grow 8 percent this year, only time will tell what the final outcome will be.  

Forecasts for crude in the short term range from $60 to $10 per barrel. While analysts and economist don’t all agree on whether we have hit a bottom, all concur that we will experience a great deal of volatility.  

It’s also fair to say that the majority don’t expect $100 oil per barrel in the foreseeable future as technological advancements have debunked the myth of peak oil. 

 

Source: Bloomberg

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.  

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