This is what’s really wrong with oil

February 15, 2016 9:45 PM0 commentsViews: 29990

This is what's really wrong with oilThis is what’s really wrong with oil

In mid-2014, crude oil prices were about $100, depending on which grade you wanted to buy. Now prices hover near $30—roughly a 70% decline in 18 months.

The ongoing oil price collapse is having a severely negative impact on the wealth of those who own oil reserves. Western oil companies and OPEC member states, however, aren’t so worried about oil reserves in the ground.

The number one problem is oil on the surface.

There’s Too Much Oil in the Market

Supply far outstrips current demand—which, as we know from Econ 101, yields lower prices. The International Energy Agency said in its January market report that “unless something changes, the oil market could drown in oversupply.”

Is that really true? Drowning is certainly a poor analogy. Drowning is final: you don’t recover from it. We might be bearish on the oil market, but we haven’t written it down to zero.

The problem is finding the balance between supply and demand. The current situation is primarily a result of higher supplies and only secondarily of demand weakness. The world still burns plenty of oil and will keep doing so for many years.

Oil Producers Can’t Control Net Supply
The higher supply has come largely from US and Canadian shale fields as well as the 2014 Saudis’ decision to maintain production levels. Iran’s forthcoming return to the market will add even more supply.

These factors add up to an interesting group dynamic. All oil producers would benefit if production fell and prices rose—but they would not benefit proportionately unless the production cuts were also proportionate.

There is no mechanism or incentive to make it happen that way. Even OPEC, which in theory is a cartel with strict quotas on its members, has no way to enforce its will.

(One thing we know about OPEC members is that they cheat. Always and everywhere, when it is possible, they cheat. Saudi Arabia simply got fed up with being the fall guy. The reasons behind the Saudi strategy are complex, but I am sure an ancillary benefit, from their point of view, is that current Saudi production demonstrates to their fellow OPEC members what noncompliance on quotas will cost them all.)

Debt Pushes Producers to Sell Oil at a Loss
Add in the further complication that shale oil fields, by their nature, are easy to turn on and off. If your oil costs $40 a barrel to produce and you can sell it for only $35, you can cap your wells and wait for higher prices.

But here we hit another problem.

If you borrowed the money to drill your wells in the first place, you need cash flow to service your debt. So you might keep pumping even if you only break even or run a small loss.

That seems to be what many small US producers are doing. The alternative is to default on their bank loans or high-yield bonds.

Indeed, the high-yield bond market seems to have calculated that more defaults are coming. Bond prices have collapsed as low oil prices make it hard to stay current on debt payments.

A Dilemma
What will be the endgame here? If companies default and go into bankruptcy, courts will sell their assets to the highest bidder. Bondholders will push for quick liquidations.

If the assets consist of oil in the ground that can’t be profitably extracted, who will buy those assets?

I don’t really know. I’ve been told the major multinational producers are biding their time, hoping to buy those reserves on the cheap. I also know for a fact that drilling rigs and ancillary production items are going for ten or twenty cents on the dollar at auction.

The cost of drilling new wells is going to be down in the next cycle. The unanswered question is whether the currently producing wells will actually stop pumping during this shake-down process, and if they do, for how long.

Producers face quite a dilemma.

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