Following the 2008 financial crisis, ultra-low
interest rates, three rounds of quantitative easing in the U.S. and a risk-on
atmosphere provided vast amounts of capital (both debt and equity) to U.S.
producers, who quickly put it to work drilling and franking.
As a result, more than four million barrels per day of
production was added at a time when there just wasn’t enough demand globally.
Not surprisingly, the Saudis and their fellow OPEC members lost patience along
with market share, and responded in kind by bringing on an additional 1.5
million barrels per day from mid-2014 through to mid-2015.
World Liquids Market Balance.
The price of oil
quickly responded to the supply-demand imbalance of approximately two million
barrels per day.
Unfortunately, just when you thought it couldn’t get
any worse, Iran is about to hit the market with an immediate 500,000 barrels of
oil now that its sanctions were lifted on Saturday.
In the midst of such a mighty storm, it’s very hard to
imagine that it will eventually come to an end, especially when the primary
focus at the moment is just on surviving the onslaught.
But we believe the clouds will eventually break since
the sheer magnitude and duration of oil’s ongoing pricing collapse will
eventually self-correct, as will the current supply-demand imbalance, perhaps
even sooner than many expect.
The solution will likely come from where the problem
began — U.S. shale producers.
Having covered the industry as a sell-side analyst,
I’ve seen my fair share of reservoir models and production profiles. Shale
wells have what is termed a hyperbolic decline curve, meaning they have upwards
of a 75-per-cent decline rate in production in the first one to two years
before they stabilize at substantially lower levels. They require continual drilling
and a lot of capital reinvestment just to keep production flat, let alone grow
Capital markets closed for business early last year
and debt markets quickly followed suit, so these producers have had to rely on
rapidly falling cash flows to continue drilling wells.
The average U.S. producer was using more 80 per cent
of its cash flow just to service interest payments when oil was at US$50 a
barrel. Imagine the situation at US$29 a barrel, or even negative oil prices
for North Dakota Sour crude.
As well, the rig count has fallen nearly 70 per cent,
with most of the drop occurring in early 2015, so we really have yet to see the
lag impact on oil production. (Figure 8)
When that impact comes, both the speed and magnitude
of the fall in production may surprise many and there will be little that can
be done to stop it given the massive staffing cuts at North American service
and production companies and a quickly aging and under-maintained fleet of
service and production equipment.
Brace yourself for another stomach-churning ride. While predicting
changes in the price of oil is a fool’s errand, at least two volatile scenarios
lie ahead, and neither is promising. On the one hand, oil prices are likely to
stay unacceptably low through 2016. On the other, today’s bust is likely to lay
the basis for a sharp price spike down the road.
Today’s oil glut is different from those of the past: It is due to the
near-doubling of U.S. production of shale oil since 2009, as well as the
response of Saudi Arabia and other petroleum exporters to this unwelcome
competition. In the short term, the lifting of sanctions against Iranian oil
will not help. While prices in the $20-30 per barrel range were once considered
beneficial to the economy and the stock market, this is no longer the case. Low
prices have led to painful budget cuts in North Dakota, Texas, Louisiana, New
Mexico, Alaska and California; a $300 billion decline in capital investment in
future extraction this year alone; the bankruptcies of dozens of energy
companies; and the undercutting of incentives to build alternative clean
Most immediately, low prices are a catalyst for the rise in global
conflict. Cheap oil translates into huge revenue losses and increased poverty,
especially for Russia, Brazil and Mexico but also for Canada. In the 10 OPEC
countries where oil comprises more than 85 percent of export revenue, the
consequences are especially dire. Where regime stability rests on a classic
“oil pact” (that is, the provision of economic benefits to key constituencies
in exchange for political support or, at least, passivity), low prices create a
toxic mix of weak currencies, inflation, growing debt, budget and trade
deficits, rising food prices, cuts in essential services and soaring poverty.
Such a grim prognosis traditionally spells the downfall of fragile
governments—and, sometimes, even regimes that appear stable. In Venezuela,
which is already in a constitutional crisis, this year’s projected 10 percent
economic contraction will plunge its extremely polarized population into even
more intense civil conflict. The already dangerous situation in the Middle East
and North Africa will be intensified. Because national boundaries in that
region are not resolved and political institutions are crumbling, the grim
economic forecast for oil-exporting governments makes them less capable of
appeasing their populations or securing their oil facilities and pipelines in
the face of vicious insurgencies. The Islamic State, for example, lives off the
earnings from oil fields in Syria and Iraq, and similar dynamics fund Boko
Haram in Nigeria and al Qaeda affiliates in Central Asia and the Caucasus.
Ironically, one likely impact of this oil glut is a future price spike.
Despite all the current hype, only a relatively thin margin separates surplus
from shortage. Global crude oil production has already dropped substantially,
with U.S production falling to 2008 levels. The delayed actions of major
producers like Chevron and ExxonMobil, which are holding off planned
large-scale oil projects—and, hence, millions of barrels of future supply—has
the potential to fuel a surge in prices as early as next year. And widespread
conflict in oil regions—exacerbated by low and unstable oil prices—could
significantly disrupt supply at almost any time.
Oil-related violence underlies almost all of today’s major hotspots,
even those conflicts that appear solely ethnic or religious in nature,
including the Syrian Civil War and its spillover into Iraq, growing tensions
between Iran and Saudi Arabia, and the continued civil unrest in Yemen,
Afghanistan, South Sudan, Nigeria, Algeria, Somalia, Libya and the Sahel,
Russia and the Ukraine and Venezuela, to name a few. Many of these
governments—including, notably, Russia and Saudi Arabia—have every incentive to
take aggressive nationalist political action abroad to deflect attention from
deteriorating economic conditions at home.
Whether oil prices stay too low or suddenly spike, their very volatility
perilously whiplashes both winners and losers, destabilizes economies and
polities and encourages war—a compelling reason to look for new sources of
energy, just in case climate change alone was not enough reason to get off the
fossil fuel roller coaster.