$20 a barrel oil?

Last week, Goldman Sachs released a research report to clients in which it observed that if the world oil market develops in a less favorable way (to oil producers) than it currently anticipates, the crude oil price might plunge to as low as $20 a barrel before enough production is removed from the market for prices to stabilize.

This “doomsday” scenario has, naturally enough, captured all the press headlines.  I haven’t seen the GS report, but I do know the factors involved.  They are:

forces for price stability around $40 a barrel

  1.  Under normal conditions in a commodity market, when oversupply develops prices fall to a level below the out-of-pocket production expenses of the highest-cost producers.  This eventually causes them to stop generating output.  The reduction in supply stabilizes prices.  If producers mothball their operations and fire their workers, that itself may be enough to start prices rising again.
  2. Even for producers who are still profitable at lower prices, decreased cash flow leaves them less money to invest in project expansion.  Price uncertainty may cause them to hesitate, as well.  For those who have borrowed heavily, contracts with their lenders may force them to divert cash away from operations toward debt repayment.

forces against stability

  1. Many members of OPEC, which accounts for about a third of world oil production, have relatively simple economies that are heavily dependent on oil to fund government spending and to provide money to ordinary citizens.  Where the textbook economic response to lower prices may be to produce less, in order to maintain government plans and services (keeping citizens happy) the only response from OPEC is to produce more to generate more income.  This is arguably self-defeating   …and makes the problem worse.  Still, OPEC has raised production by about 2 million barrels a day over the past months.  And Iran is saying that once sanctions are lifted, it will begin to sell 100,000 barrels of oil a day, with presumably more in the offing.
  2. At, say, $100 a barrel, producers of petroleum from oil sands or shale have had no pressing incentives to hone their techniques.  At $40 a barrel and facing potential shutdown, they’re becoming much more inventive.  So they are finding ways to lower their costs to keep delivering output to market.

oil storage

We know that the world is now being supplied with more oil than it needs because oil inventories are rising.  Middlemen continue to be content to buy from producers because they can immediately sell for future delivery at a profit through derivatives and store the stuff in the mean time.

My experience is that although the markets have a rough idea of how much storage capacity there is–in giant storage tanks, barges, tanker ships…,  the reality is that there’s always more capacity than the consensus suspects.

What happens when every storage container is full?    …no one buys oil that comes on the market because there’s no place to put it.

the doomsday scenario

Three parts:

–shale oil producers lower their costs so that their production doesn’t fall by the 500,000 barrels/day that the market expects

–storage gets all filled up

–OPEC keeps on increasing production because it needs the money.

Middlemen turn the stuff away.  Prices plummet.

probability?

I’m not worried, so I guess I think it’s low.  In reality, no one knows.

Goldman has credibility in this field not only because it has strong commodity trading operations, but also because years ago it predicted $100+ per barrel oil when no one else thought it was possible.

Tomorrow, consequences of doomsday, were it to happen.

 

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