what would $20 a barrel oil mean for stocks?

Yesterday I wrote about the recent Goldman report speculating that oil might fall to $20 a barrel.

What would this mean for stocks?

a $40 ceiling…

To my mind, the most important observation is the simplest–the potential price fall would be caused by more oil being supplied than the world wants or needs or is able to store profitably for future use.  The price would decline to force marginal production off the market.

In other words, there’s significant oversupply at $40 a barrel.  Therefore, $40 becomes the new ceiling for oil, which would presumably bounce between it and the floor of $20.  The $60-$70 a barrel level, which markets now believe to be the near-term price ceiling, becomes a pipe dream.

…that would be hard to break through

Yes, demand for oil has been showing a trend rise of about 1% per year, and a lower price will encourage higher use but since the extent of oversupply is hard to know for sure, the safest assumption, I think, is that it would take a looong time to break through the $40 ceiling.

substitutes are hurt

A lower oil price makes substitute forms of energy–from coal and natural gas to nuclear to wind and solar–relatively less attractive.  In the US, we’ve already seen demand for automobiles is shifting away from fuel efficiency to gas guzzling because of $40 a barrel oil.  This trend to would likely accelerate if oil falls more.  Of course, by spurring more profligate use of oil, this trend should sow the seeds for future oil price increases.  Still, my guess is that upward price pressure takes a long time to develop.

producers vs. consumers

countries

Lower prices would be a boon for oil-consuming nations.  For developing countries dependent on oil production for economic growth, however, lower prices would force significant–and possibly very politically messy–structural change.  We’re already seeing this in Saudi Arabia, for instance.

industries (in the US)

Financially strapped oil producers would be in worse trouble than they are now.  Bad, too, for oil-related junk bonds.  The same for regional lenders specializing in oil and gas loans.

Seen from 30,000 feet, the US is a complex economic case.  Shale oil has allowed the country to displace Saudi Arabia as the #1 oil producer in the world.  On the other hand, the US is nevertheless a huge importer of foreign oil (per capita, we use twice as much oil as anyone else on earth).  While oil-producing regions–Alaska, Texas, Oklahoma, North Dakota…–would suffer from lower oil prices, the rest of the country would have its already low oil bills cut in half.

stocks

the minus column

oil producers

producers of other forms of energy

companies located in oil-producing regions

the plus side

US auto firms

oil refiners

transport companies, like airlines and truckers

consumer companies, helped by the boost to disposable income from less spent on petroleum products

??strip malls, Wal-Mart, resort destinations, other firms consumers typically drive to

businesses serving less affluent customers, who would have the greatest percentage boost to disposable income

 

 

 

 

 

 

$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.