The Problem With Oil Prices Is That They Are Not Low Enough

Posted in The Petroleum Truth Report on October 20, 2015

The problem with oil prices is that they are not low enough.

Current oil prices are simply not low enough to stop over-production. Unless external investment capital is curtailed and producers learn to live within cash flow, a production surplus and low oil prices will persist for years.

Energy Is The Economy

GDP (gross domestic product) correlates empirically with oil prices (Figure 1). GDP increases when oil prices are low or falling; GDP is flat when oil prices are high or rising (GDP and oil price in the figure are in August 2015 dollars).

CPI-Adjusted US GDP + Trendline & WTI October 2015_150

Figure 1. U.S. GDP and WTI oil price. GDP and WTI are in August 2015 dollars. Note: I use WTI prices because Brent pricing did not exist before the 1970s.
Source: U.S. Bureau of Labor Statistics, The World Bank, EIA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

This is because global economic output is highly sensitive to the cost and availability of energy resources (it is also sensitive to debt). Liquid fuels–gasoline, diesel and jet fuel–power most worldwide transport of materials, and electricity from coal and natural gas powers most manufacturing. When energy prices are high, profit margins are lower and economic output and growth slows, and vice versa.

Because oil prices were high in the 4 years before September 2014 and the subsequent oil-price collapse, GDP was flat and economic growth was slow. That, along with high government, corporate and household debt loads, is the main reason why the post-2008 recession has been so persistent and difficult to correct through monetary policy.

Why Oil Prices Were High 2010-2014 and Why They Are Low Today

Brent oil prices exceeded $90 per barrel (August 2015 dollars) for 46 months from November 2010 until September 2014 (Figure 2). This was the longest period of high oil prices in history. Prolonged high prices made tight oil, ultra-deep water oil and oil-sand development feasible. Over-investment and subsequent over-production of expensive oil contributed to the global liquids surplus that caused oil prices to collapse beginning in September 2014.

Chart_Surplus-Deficit-2011-15

Figure 2. Brent price in 2015 dollars and world liquids production deficit or surplus.
Source: EIA, U.S., U.S. Bureau of Labor Statistics and Labyrinth Consulting Services, Inc.
(click image to enlarge)

Oil prices were high during during the 4 years before prices collapsed because world liquids production deficits dominated the oil markets. This was due mostly to ongoing politically-driven supply interruptions in Libya, Iran, and Sudan beginning in 2011. The easing of tensions particularly in Libya after 2013 along with increasing volumes of tight and other expensive oil led to a production surplus by early 2014 (Figure 3). Before January 2014, supply was less than consumption but afterward, supply was greater than consumption.

World Supply-Demand_Oct 2015

Figure 3. World liquids supply and consumption, and Brent crude oil price.
Source: EIA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

The global production surplus has persisted for 21 months and supply is still 1.2 million barrels per day more than consumption. This is the main cause of low oil prices that began in mid-2014.

Why Over-Production Continues

Actions taken by the U.S. Federal Reserve Bank to stimulate the economy after the Financial Crisis in 2008 were partly responsible for high oil prices and for the over-production of tight oil in the U.S. that eventually caused oil prices to collapse in 2014.

The U.S. central bank lowered the Federal Funds Rate–the interest that it charges for loans to commercial banks–from approximately 5.5% before the 2008 collapse to 0.2% in late 2008 (Figure 4). By mid-2014, the rate had dropped below 0.1%.

M1 Money Supply 5 October 2015
Figure 4. U.S. Federal Funds interest rates, M1 money supply and CPI-adjusted WTI crude oil prices.
Source: EIA, U.S. Bureau of Labor Statistics, U.S. Federal Reserve System and Labyrinth Consulting Services, Inc.
(click image to enlarge)

At the same time, the Federal Reserve Bank increased the U.S. money supply (Figure 4) from about $1.4 trillion before the 2008 collapse to more than $3 trillion today as part of a policy called Quantitative Easing (QE). QE involved creating money to buy U.S. Treasury bonds. This lowered the yield that these bonds paid and forced investors into riskier investments like the stock market and U.S. exploration and production (E&P) company bonds and secondary share offerings.

There is a negative correlation between the value of the U.S. dollar relative to other currencies and oil prices (Figure 5). When the U.S. dollar is strong, oil prices generally fall and vice versa chiefly because worldwide oil commodity trades are denominated in dollars.

US Dollar & CPI Brent 2000-2015
Figure 5. U.S. trade-weighted dollar value and CPI-adjusted Brent crude oil prices.
Source: EIA, U.S. Bureau of Labor Statistics, U.S. Federal Reserve System and Labyrinth Consulting Services, Inc.
(click image to enlarge)

Quantitative Easing, the increase in the U.S. money supply and artificially low interest rates resulted in a weaker U.S. dollar that was a contributing factor to higher oil prices after 2008 (an OPEC production cut in early 2009 was another important factor). The end of QE in mid-2014 and a resulting stronger U.S. dollar corresponded with the collapse in world oil prices (Figure 5).

The relationship between interest rates, money supply, the strength of the dollar and oil prices is complicated and I do not mean to over-simplify its complexity. The observed patterns are, nevertheless, interesting and useful for understanding the broad trends of the last several years at least on a high level.

The net effect of all of these monetary policies was to undermine conventional, passive investments–savings accounts, CDs, U.S. Treasury bonds, etc.–because of low yields (1- 2.5%). Investors were driven to the U.S. E&P sector where high-yield (“junk”) bonds and secondary share offerings provide yields of 6-10%. These investments are based on a coupon payment or dividend and not on the company’s success unless, of course, the company goes bankrupt.

This and other risks are rationalized by the fact that the investments are in the fiscally “safe” United States, are backed by a hard asset–oil and gas–in the ground, and that even if a company becomes distressed, it will likely be bought and the investment preserved.

More than $61 billion has flowed to North American E&P companies so far in 2015 both as equity and debt (Figure 6). This is more than in any previous year despite low oil prices, plunging stock prices and poor financial performance for most E&P companies.

Greasing The Skids Graphic with Bloomberg Added 18 Oct 2015

Figure 6. Private equity capital directed to North American energy companies.
Source: Wall Street Journal (September 3, 2015) and Bloomberg Businessweek (October 15, 2015).
(click image to enlarge)

The only expectation from the financial markets is apparently that production and reserves grow or are at least maintained.

A weak global economy, the monetary policies that were used to strengthen it, and world geopolitical events combined to produce a surge in expensive oil production that was made possible by high oil prices and almost infinite access to capital by producers.

Now that oil prices have fallen by half, many expected that production would fall sharply.

That has not happened because capital supply has not fallen with lower prices but has increased. To be sure, U.S. production has declined and will decrease further. EIA’s forecast (Figure 7) suggests that it will fall approximately 940,000 bopd from its peak in April 2015.

Chart_US Prod & Forecast

Figure 7. EIA crude oil production and forecast.
Source: EIA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

The U.S., however, is not the world and less than a million barrels per day of lower U.S. oil production will not make much of a difference in the global surplus. Although world production has declined somewhat, it is still 850,000 bpd higher than its 2014 peak and a supply surplus persists (Figure 8).

Chart_Prod-Cons-Surplus
Figure 8. World liquids production, consumption and production surplus or deficit.
Source: EIA and Labyrinth Consulting Services, Inc.
(click image to enlarge)

Global producers are similar to their U.S. counterparts. Most of them must also satisfy investor expectations, have considerable access to capital, must maintain cash flow, even at a loss, to service debt, and have benefited from greatly reduced oil field service costs that accompany lower oil prices.

The Problem With Oil Prices Is That They Are Not Low Enough

Brent international oil prices have averaged more than $55 per barrel ($51 for WTI) in 2015. As long as prices remain in that range, I doubt that production will fall enough to balance the market for several years or more barring a surge in demand or renewed supply interruptions.

Figure 9 shows that the long-term average oil price (1950-2015) is $45 per barrel in August 2015 dollars.

CPI Oil Prices 1950-2015_Baselines & Avg Prices 15 Oct 2015
Figure 9.  WTI oil prices in August 2015 dollars, January 1950 – August 2015.
Source: EIA, U.S. Bureau of Labor Statistics and Labyrinth Consulting Services, Inc.
(click image to enlarge)

Before the Arab Oil Embargo (1973-74) and the beginning of the Iran-Iraq War (1980), the average price was $23 per barrel. In the 1986 to 2003 period after these oil shocks and before the Financial Collapse, prices averaged $34 per barrel.

These prices seem quite low from our sticker-shocked perspective of the early 21st century, yet oil companies made profits when prices were $15 to $25 real dollars per barrel less than they are today. More importantly, those periods of low oil prices were also times of economic growth and prosperity (Figure 1), whereas the intervening periods of higher oil prices were times of low economic growth.

Capital will continue to flow to E&P companies as long as high yields on bonds and secondary share offerings are paid. Sustained oil prices in the $30-40 range would create sufficient distress among high-cost zombie producers to cause defaults on those offerings. This alone will stop the capital enablers–the investment banks–from directing funds to the E&P sector.

Many believe that the upcoming credit re-determinations and year-end reserve write-downs will greatly limit available capital, and that this will lead to oil market balance. I hope that they are right. I suspect, however, that the capital enablers will stay the course despite higher risks simply because they are unable to identify alternative investments that offer a comparable yield.

Some like OPEC and Wood Mackenzie believe that demand growth will balance the oil market. I also hope that they are right. Others, however, like the IEA take a more pessimistic view because of a weak global economy. The IEA’s view of the economy seems sound to me and I am, therefore, doubtful that demand growth will balance the market.

Still others are hopeful that OPEC will cut production and that will balance the market. I don’t believe that will happen. A production cut would accomplish little except perhaps for a short-term increase in prices that would result in higher cash flows and a rebound in drilling activity–in short, it would compound the problem of over-supply.

The only way to achieve oil market balance is for prices to go low enough for long enough to stop the flow of external capital to the producers and to force them to live within cash flow. The intriguing aspect of this proposition is the possibility of a return to economic growth that has so far eluded the best efforts of central bankers and economists.


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20 comments on this entry


  1. I have a question on shale oil. We are told there are sweet spots where it is profitable. OK. We seem to be drilling a lot of wells in them. I’m not sure how many wells there are to the square mile, or how many we are drilling, but it seems that someday soon we may run out of sweet spots to drill. So perhaps in a decade we’ll be out of cheap shale oil and into very expensive oil.

    Maybe that is too far out, but I wonder if you have any feel for this. When they are all drilled, then shale oil will be way over 100/barrel.


  2. Dick,

    The sweet spots constitute about 15% of the total play area. There are enough locations for a few more years of infill drilling in the Bakken and Eagle Ford plays. This is consistent with tight oil proven reserves published by the EIA and with the EIA annual energy outlook that indicates a peak of U.S. production in 2020. This is a significant revision to their AEO 2014 forecast a year earlier that suggested a peak in 2015 or 2016. David Hughes has called this newer forecast into question because there seems to be no basis for it; in other words, there are no new plays or new pool discoveries that seem to warrant an increase.

    Your suggestion that there may only be a few years of U.S. production surplus, therefore, seems well founded.

    All the best,

    Art


  3. Art,

    I am afraid that this article was not very convincing. Why did it focus only on North American oil investments? Doesn’t it make more sense to look at capital expenditures by E&P companies worldwide, which have fallen sharply in 2015, by around 20%?

    The main evidence advanced to support its thesis that unless “external investment capital is curtailed and producers learn to live within cash flow, a production surplus and low oil prices will persist for years” is a chart from a WSJ article “Private-Equity Firms Plunge Back Into the Oil Patch” from September 3, 2015 (http://www.wsj.com/articles/private-equity-firms-plunge-back-into-the-oil-patch-1441326003 ), and a reference in an article from Bloomberg, “Wall Street Sets Aside More Cash to Cover Weaker Oil Loans” (http://www.bloomberg.com/news/articles/2015-10-14/wall-street-setting-aside-more-cash-to-cover-weakening-oil-loans). Although the raw data referred to in those articles is not given, they appear to refer only to North America or to the U.S., more specifically. Also, they refer to investments by provate equity firms and to issuance of debt and equity by E&P companies………..they didn’t say what this money is being used for. Is it being used for capital expenditure? Or to roll over pre-existing debt? There are reasons to suspect the latter explanation rather than the former.

    Regards,

    Paul


  4. Paul,

    I regret that you did not find this article very convincing.

    I chose only two references for the level of external funding for U.S. E&P activity but there are reports and charts published almost weekly documenting the almost unlimited capital that has funded this production. I did not go further than two recent and highly credible sources because the relationship between capital supply, negative cash flow and ongoing activity is well known and generally accepted.

    I have published numerous previous posts that went into the detail of capex and cash flow that you suggest. Here are the latest but there are many more if you search my blog:

    http://www.artberman.com/the-party-is-over-for-tight-oil-but-raymond-james-says-party-on-dude/

    http://www.artberman.com/john-mauldin-defends-the-faith-fails-economics-101/

    http://www.artberman.com/a-year-of-lower-oil-prices-crossing-a-boundary/

    As I said in the article, “The U.S., however, is not the world.” At the same time, the trigger for the world over-supply of oil was clearly the increase in production from the U.S. and, to a lesser degree, from Canada. The world, therefore, looks at U.S. production and its increase or decrease as a leading indicator for where the market balance and oil prices are going.

    I cannot fault you for not reading all of my posts but I feel that your concerns are quite adequately addressed in my work.

    All the best,

    Art


  5. Art,

    In your article you express the view that lower oil prices would balance the market rather sooner than later. As natural gas prices are extremely low – even on an inflation adjusted basis – I am wondering if you think that natural gas supply will decline substantially in the next future.


  6. Heinrich,

    U.S. gas production has been flat for several months largely because of low prices in the Marcellus Shale and declining production from older shale gas plays. I plan to publish a post on this subject in the very near future.

    Thanks for your comments,

    Art


  7. Art,

    Thanks for your reply, which I appreciate, and for your analysis, which I respect (and I read and enjoyed all of the insightful posts that you mentioned).

    The big point that I was trying to make was that U.S. shale oil production is only around 5% of total World oil production. However, it has played an outsized role in the market, as no doubt its rapid increase in the past five years was what prompted the Saudis to flood the market and push prices down. And their strategy is working, as U.S. production has fallen by 500K barrels over the past six months.

    But the price collapse did not ONLY affect U.S. shale oil producers. Most of the ~$150bn in capex that it averted over the past year was not for shale oil. The lower production as a result is slower to manifest itself than for the quick-reacting shale oil producers, but when it DOES manifest itself, it may help to balance the market.

    Paul


  8. Paul,

    Yes the world is a big place with lots of moving parts, and the U.S. drop of 514,000 bopd is not enough to make a big difference. However, the total increase from around 5 mmbopd in 2008 to more than 9.5 mmbopd in June 2015 (and still more than 9 mmbopd this week) is very significant in the global scheme of things.

    The factors affecting all world producers are similar to U.S. tight oil producers, as I wrote, “Global producers are similar to their U.S. counterparts. Most of them must also satisfy investor expectations, have considerable access to capital, must maintain cash flow, even at a loss, to service debt, and have benefited from greatly reduced oil field service costs that accompany lower oil prices.”

    External funding is key and not just for U.S. tight oil companies.

    I don’t think that the Saudis are overly concerned about U.S. tight oil because they know it has a short life cycle. They are more concerned with oil sands that have huge reserves and a long life cycle and low prices are killing the oil sand producers.

    All the best,

    Art


  9. Art,

    I am curious as to what you think about Gail Tverberg’s analysis on respect to oil price and economic growth. Her position, if I have understood it, is that it is no longer possible for enough oil to be produced profitably at a low enough price to sustain economic expansion over any significant time period. The corollary argument is that low oil (and other commodity) prices are a function of demand destruction due to an affordability crisis. Your thoughts?


  10. Joe,

    I respect Gail’s analysis and agree with much of her rather gloomy economic view. High energy costs and too much debt make economic growth difficult.

    At the same time, energy costs have been lower for a year now and Q2 2015 U.S. GDP and GDP growth (6.1% compared to a very bad Q1 but 3.7% compared with Q2 2014) look stronger based on admittedly limited data for the second quarter of 2015. The true break-even costs for U.S. tight oil using full-cycle, all-in (except for land sunk costs and DD&A) NPV8 are more than $75/barrel on average despite what companies and many analysts claim. But U.S. tight oil break-even and conventional Middle Eastern and Russian oil are different.

    The factor that Gail does not fully accept is that demand for oil is growing albeit at a slower rate than in previous decades and lower prices have or will stimulate more demand growth.

    Gail and other of my former Oil Drum colleagues assume that all bad things happen quickly and simultaneously. I believe that the world has gotten very good at lengthening the time line of bad economic events so things don’t collapse the way some fear. The end result may be equally grim but, because it takes place over years and not months, people adjust.

    I don’t think that there will be a decade of low oil prices nor do I think that the global economy will collapse. I expect the same kind of cyclicity that has characterized energy costs and the economic response since the 1970s with the cycles having increased frequency and greater amplitude.

    I hope that this helps.

    Thanks for your comments,

    Art


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