As I was thinking about this post, I knew that oil is a complicated subject and that there’s a risk of getting lost in the details. So I decided to sketch out the structure of the post carefully on paper before I began to write. Several pages of notes later, I abandoned the attempt, in favor of extreme simplicity (I hope).
Like any other mineral commodity, oil is subject to boom and bust cycles. We’re now in bust, meaning that supply is structurally higher than demand, exerting continuous downward pressure on prices.
As with any other commodity, prices will stay low until supply and demand come back into balance. The slow way for this to happen is for demand, now at about 93 million barrels per day and growing at 1%+ per year, to expand. The fast way is for prices to stay low enough, long enough for high-cost producers to go out of business. As I see it, adjustment will primarily come the fast way.
Oil is peculiar, though, in two respects, both of which argue that prices will stay low for a considerable time:
–many major oil producing countries (e.g., the Middle East, Russia) have relatively simple economies that are radically dependent on exports of oil for government income. Over the past year, OPEC oil output has actually risen by about 1.5 million barrels per day, despite the expanding glut. This indicates that, unlike prior periods of oversupply, the group has no desire to try to moderate the downturn.
–the long-term geological damage to a big oilfield from turning the taps off and on can be great. So producers are more hesitant than in other industries to do so.
Arguably, what has upset the pricing applecart is the unanticipated surge in oil production in the US, which was 5.6 million barrels per day this time in 2011 and is 9.5 million today. Hydraulic fracturing is the reason for this.
where to from here?
US oil production is still averaging more than a million barrels per day higher than in 2014. However, the steady month by month march upward of output figures may have been broken in May, when liftings were about 200,000 barrels a day less than in April.
My guess (and I’m doing little more than plucking numbers out of the air) is that at $50 a barrel or below, new fracking projects won’t get started. Under $40 a barrel, some wells may be shut in. If a production falloff comes solely through the former mechanism, we’re probably a year away from a meaningful (translation: more than a million barrels, but after that, who knows) decline in fracking output.
That would likely mean a higher oil price then than now, IF (…a big “if”) OPEC nations desperate for cash don’t up their production further.
what I’m doing
I have no desire to buy oil stocks today, because I think we’re not that far along in getting supply and demand back into balance. In the early 1980s, for example, the entire process from top to bottom took about half a decade. I’m also thinking that there might either be another sharp price decline, or simply a further sharp selloff in oil stocks before the current oversupply is over. I’ve just started to think about what I might buy if either were to happen. One thing is certain, though. It won’t be the big oils, or tar sands, or LNG.
more than you ever wanted to know
When I started on Wall Street as an oil analyst, oil and natural gas sold for roughly the same price per unit of heating power. Natural gas has been less than half the cost of oil on a heating equivalent basis for many years, however, because it isn’t in widespread use as a transportation fuel and because it takes a pipeline to deliver it to customers. Natural gas is already being substituted for coal in power generation. Will it ever have a dampening effect on the ability of the oil price to rise?