It has been an eventful several years for crude oil markets with massive fundamental and technical pressure placed on them, and producers are playing a game of chicken to see who will blink first.
Many market experts tend to remember recent news and price levels better than past levels and accept so-called new paradigms as if they are relatively common. So, despite the historic pricing of crude, there was a belief in many sectors that it would continue to trade above $100 per barrel in strong market environments and perhaps challenge $80 in weak ones.
Even as the United States experienced a renaissance in crude oil production with the revolutionary expansion of fracking technology and geopolitical risk—with the prospect of a nuclear deal with Iran—proving to be a two-way street, most analysts were timid, predicting prices wouldn’t drop much below $90, let alone 60% in six months (see “What goes up…” below).
Perhaps there was something to those expectations because they were predicated on the belief that OPEC would not allow crude to dip below a certain level before it would choose to cut production. However, in the new world where the United States had already been projected to become the leading producer of crude oil by 2025, OPEC, and its main policy driver Saudi Arabia, saw more risk in the loss of market share than in a precipitous drop in crude oil pricing. So, while we ate turkey and watched football here in the United States, OPEC announced at its annual meeting on Thanksgiving 2014 that it would continue to pump at its current rate.
The question shifted from, “How low could it go?” to, “At what point will it no longer be profitable for U.S. frackers to keep pumping?” The market appeared to have an answer to that after bottoming out this past March, but after an impressive 50%-plus recovery, the bear returned with a vengeance this summer and took out the spring lows.
Crude bear 2
“We failed the second time because we had three once-in-a-decade events happen in three weeks,” says Phil Flynn, senior energy analyst at The Price Futures Group. “You don’t [often] see a country default to the [International Monetary Fund]. It happened with the Greece default. You had the potential lifting of sanctions on a major oil producer with some of the largest proven reserves in the OPEC cartel [and] the Chinese stock market crashed (see “Three strikes,” below). All of these events created this double dip in the price of oil.”
Flynn argues that any one of those events could have turned the market and all three occurred in a short period.
“It was all about China falling off of the cliff,” says Martin McGuire, managing director at TJM Institutional Services, who also cites expectations of a Federal Reserve rate tightening. “All commodities hate it [when the Fed tightens rates, especially] crude.”
According to Trend Macrolytics Chief Investment Officer Donald Luskin, “Oil was recovering in April and May while people were beginning to realize that U.S. shale production was not growing anymore.
In fact, it peaked in March,” he says. “That signaled that some of the oversupply would be alleviated so Brent crude got up to almost $70 in May. Then people in the know got positioned for this bombshell: The Iran nuclear deal. It immediately created the prospect that Iran, one of the largest potential producers in the world, could suddenly bring 500,000 to 1 million barrels a day to the market. That seems to have changed everything.”
While there were plenty of fundamentals to chew on, crude also appeared to be reacting to technicals. The January sell-off broke a 17-year trendline on a monthly chart, and just to show its significance, it rallied more than $3 in the last hour of the last day of the month to settle above the line (see “Toeing the line,” below).
The level was challenged in February and March, and on the second leg down it was taken out on a closing basis in July.
“That’s a very strong line and it is very disconcerting that we broke it,” says Dominick Chirichella, partner at Energy Management Institute. “I don’t see a scenario during the next three to six months that would suggest we are going to be at $60 or higher.”
Cost of production?
The assumed strategy behind OPEC’s decision last year to continue pumping was to break the back of U.S. frackers.
Chirichella makes the point that this is not the first time Saudi Arabia and OPEC have pumped oil to try and price new production out of the market.
“We went through this in 1986 for the same reason,” he says. “The Saudis embarked on market share strategy aimed at slowing the advent of North Sea and Alaskan crudes that were coming on the market at the time. It pushed prices all the way down to $10 per barrel. And then gradually OPEC started cutting production.”
Some saw it beginning to work this time.
Flynn says, “History would say when oil prices crash there are consequences such as cutbacks in capital spending and energy products getting canceled. We canceled $20 billion barrels-worth of oil projects in the last three months. This is the equivalent of the reserves of Mexico. We have seen the biggest cutbacks in the energy industry in the history of the world. When you have had this type of production cuts it has always sown the seeds of recovery.”
While acknowledging that U.S. share production may have peaked this spring, Luskin says that doesn’t necessarily mean a rebound in prices. “The thing that brought [crude oil down to $37.75 in late August] was that most of the frackers had funded their activities with debt and were having a hard time paying some of those debts,” Luskin says. “The frackers are in a position of having to produce any oil they possibly can in order to meet their cash flow requirements to meet their debt payments. We are talking about finance here where low oil prices create even lower oil prices because the lower the price goes the more desperate these people get, and the more desperate they get the more oil they have to produce, and the more oil they have to produce the lower the oil prices go, and the lower the price goes the more desperate they get. It is just completely unpredictable when the vicious cycles works itself out—maybe it already has.”
So, the cost of production is not necessarily a barrier for price. But Luskin argues that the cost of production is a moving target.
“It is a moving target and a declining target,” he says. “The calculation of what it cost for a fracker to produce a barrel of oil is leasing the land, getting the rig, drilling a vertical two miles down, drilling the lateral, fracking it and trucking it to a train station.”
That is a complete cycle cost but many producers have established wells. “Drilling that vertical is the most expensive part of the operation,” he says. And if that is already done, breakeven can be between $15 and $30. “The problem is, once they use up all those expensive verticals, they have no business. If oil prices are where they are now, they are not going to be able to go back into the high yield bond market and get the money to actually spend $10 million to drill a new vertical.”
However, it is clear that technological advances have created efficiencies for producers.
IDC Research Director for Oil and Gas Chris Niven says some firms can definitely make money at these price levels and efficiencies should only increase. “They are reinventing themselves. You see oil companies that are now drilling multiple wells on oil well pads, you see manufacturing techniques that have been streamlined,” Niven says. “They can produce one well right after another and have all the equipment and supplies right where they need them, which implies that they are not only streamlining processes and work flows, but implementing leading edge innovative technologies.”
While a long way off, Luskin expects efficiencies to continue. “The fracking revolution has completely changed the industrial dynamics of the energy industry,” he says. “There is no such thing as peak oil. The supply of oil is now infinite. That has never been true before.”
Luskin adds that the current technology is relatively new and additional efficiencies will come. “Think of what we can do now with semi-conductors and transistors. We can now make semi-conductors so small and so inexpensive that things like the iPhone are possible; you now get credit cards with chips in them for free,” he says. “You give fracking another five years, and in another 50 years oil will be free.”