Crude Oil prices – “Caught between “Iraq” and a hard place”

In less than a year, the price of crude oil has (literally) halved. Actually, it has more than halved – Brent crude was trading at around $115 per barrel last June and closed on Friday the 6th of February at around $57. A drop of 50.4% to be precise.

Hectic scenes indeed. To say this collapse has been vicious would be an understatement. Why did this happen?

Brent Crude Oil Price Final
If I had a dollar (U.S. please) for every time I have heard the term “oil glut” in recent months I would indeed be a very wealthy man!

What exactly is a “glut”? The Oxford English Dictionary defines the word “glut” as follows:

verb (used with object), glutted, glutting.
1.    to feed or fill to satiety; sate:
       to glut the appetite.
2.    to feed or fill to excess; cloy.
3.    to flood (the market) with a particular item or service so that the supply greatly exceeds the demand.

Traditional economics teaches us that for a price to drop there can only be two reasons:
1.   There is a decrease in relative demand; or
2.   There is an increase in relative supply.

It therefore follows that for us to be experiencing an oil “glut” (as defined) the decrease in price must have been brought about mainly by an increase in supply, which far outpaces an increase (if any?) in demand.

Crude Oil remains, and will remain for a very long time, central to the functioning of all developed economies. Simply put, we are of the view that it was not unexpectedly weak demand but an ever increasing U.S. crude oil supply that was the straw that broke the camel’s (of Middle Eastern variety perhaps?) back. It is true that global GDP growth has been a little disappointing for several years, but hardly dramatic enough to cause the damage that has been wreaked in the crude oil market. Further, slow growth has been with us since 2009 and it is safe to assume that the crude oil market would have adjusted to it by now. Perhaps an increase in oil efficiency is to blame? Once again, however, efficiency of crude oil usage has been unsurprising at best. In great contrast to the picture for crude oil usage and efficiency, lets actually uncover the real drama.

U.S. Dry Shale Gas FinalFigure 1 - Source: U.S. Energy Information Administration

Supply of oil from fracking in the U.S. alone went from 0,4% to 4,3% of global production in 5 years! For U.S. oilmen (and women) they can be forgiven for thinking that they are back in the oil rush of the 19th century! For the two years ending 2014, U.S. fracking production equaled 100% of the increase in global oil supply and the forecast (before the collapse of doom) for 2015 was another 100% increase. This increase in supply has taken everyone by surprise, especially OPEC.

Faced with the reality of new U.S. fracking oil seen to be overtaking modestly growing global oil demand, OPEC knows full well that it would have to cut back production if the price were to stay anywhere around $100 a barrel (which is the price many people believe is required to justify ongoing traditional oil exploration). However, the Saudis declined to pull back their production and the oil market entered into glut mode (as defined so succinctly!). Under glut conditions, a commodity such as crude oil should always decline toward marginal cost.

Oil demand is notoriously insensitive to price in the short term but cumulatively and substantially sensitive as a few years pass. The Saudis are obviously expecting that these low prices will turn off U.S. fracking. We believe they are right. Almost no new drilling programmes will be initiated at current prices and it is fact that within 4 years, 85% of all production from current wells will be gone! It follows, from a marginal cost perspective, that for the following few years, U.S. fracking costs will determine the global oil balance. In five to eight years, depending on global GDP growth and how quickly prices recover, U.S. fracking production will start to peak out and the full cost of an incremental barrel of traditional oil will become, once again, the main input into price. This is believed to be about $80 today and rising.

Therefore, and based on the above reasons, we believe the reason for the glut is not complicated: an unprecedented and largely unexpected series of increases in U.S. fracking production combined with a refusal on the part of OPEC to cut back. Simple really (everything is simple in hindsight!).

So what happens now? A lot of market commentators and U.S. shale operators have said that increased fracking production would happily continue as usual even at oil prices below $40 per barrel. Really? It was not clear that the U.S. frackers were making very good money collectively at $100 a barrel. Now, at $50 their cash flow drops by $50 a barrel (less taxes, etc.) and we are supposed to believe that they are “whistling while they work”. Rigs are being rapidly withdrawn and fracking wells are depleting (by definition). The number of active rigs in the U.S. fracking for oil was 1,609 in October 2014 and in January 2015 this number was 1,223. It is predicted that the number of active rigs will fall convincingly below 1000 by year end. Up to 60% of all of the available oil from fracking is often delivered in the first year!

Oil Production Curve FinalFigure 2 - Source: North Dakota Industrial Commission - Department of Mineral Resources

And this is a key point: U.S. fracking is the only important component of global supply that can turn up almost immediately by bringing in new rigs and drilling wells in under two weeks, adding 20-30% to production in a year as it did for each of the last two years. It is also the only important component that can turn off quickly by depleting almost completely in three years. As Jeremy Grantham said so succinctly in his recent article in Fortune magazine - “as with Alice’s Red Queen, if you pause for breath in fracking you go backwards”. In other words, more wells must be drilled all the time to even stay still as the number of rapidly depleting wells builds up behind you.

Lower oil prices and greatly reduced capex will guarantee that oil from fracking will start decreasing this year and that the supply of traditional oil will be less than it would have been. Indeed, at recent prices very few, if any, new drilling programs will be started. But right now we have a substantial excess of production, and oil demand is notoriously inelastic to price in the short term – people will not be leaping into their cars to celebrate lower gas prices. But with time they may drive an extra 5% percent here and elsewhere or trade up to a more expensive gas-guzzling SUV (no doubt financed at ridiculously low credit rates) and the excess will slowly clear: we believe possibly by mid-year and almost certainly by the end of next year.

After supply and demand come into balance, the price initially is likely to rise slowly, held in check by the increasing amounts of U.S. fracking oil that can be profitably produced at each new higher price level. It is this rapid response rate that will make the frackers the key marginal suppliers. This phase will likely end only when fracking production, even at much higher prices, tops out; as it most likely will in the next five years. After that, we are of the belief that oil dynamics will revert to the relatively more stable and more knowable ones of the 2011 to 2013 era, in which the price of oil will be the full cost of finding and developing incremental traditional oil, which by then is likely to be well over $100 a barrel.

What does this have to do with Iraq? Nothing really. We liked the obligatory witty (albeit lame) title and thought we could bring Iraq into the mix somewhere as a large oil producing nation. We couldn’t, sorry…but we still like the title.

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