Oil Prices Should Continue to Slide
March 17, 2017
On March 7 oil market participants suddenly realized that that oil inventories had reached a record high level. Almost overnight oil prices fell by $5.00 per barrel. Our sense is that the $55 price in late February will probably turn out to be the high price for the year. Why? Because at that level U.S. producers turned on the spigot. As supply began to rise inventories also began to climb. That, ultimately, caused prices to fall. A dramatic change in the oil market in the past seven years appears to have put an effective cap on oil prices at about $55 per barrel.
Since the turn of the decade technological developments in the oil market like hydraulic fracturing and horizontal drilling have allowed oil drillers to profitably pump oil from previously inaccessible locations. As a result, U.S. oil production has essentially doubled during that period of time. The oil industry has been turned topsy-turvy by these technological advancements which have dramatically and permanently increased the global supply of oil.
As U.S. output surged by early 2015 inventory levels climbed to what were then record high levels.
Eventually prices fell from a high of $107 in late 2014 to a low point of about $28 per barrel.
As oil prices declined drillers found that many of their existing rigs could not be operated profitably and in 18 months they shut down 80% of the rigs that had been in operation in October 2014 when oil prices began to collapse.
While the number of rigs in operation fell 80% oil production dipped by only about 12%. How can that be? Easy. Oil producers became much more efficient and output per rig climbed from about 800 million barrels per day prior to the introduction of this new technology to 4,500 million barrels daily (the blue bars in the chart below). To put that in slightly different terms, the oil drillers marginal cost of production fell from about $80 per barrel prior to the introduction of this new technology to about $45 per barrel currently – and their efficiency continues to climb by about 30% annually which implies even lower costs of production in the years ahead.
Upon reaching a low point of $28 per barrel oil in the middle of last year prices have rebounded to about $55 per barrel. Suddenly drillers found that they can once again produce oil profitably. The number of rigs in operation has increased from a low point of 404 thousand to 789 thousand.
And as the number of operating rigs has climbed oil production is back to within 5% of its previous peak.
But that creates a problem. A pickup in production of that magnitude has created a situation where oil inventories in the U.S. have surged to an even higher record level.
Given this backdrop it is perhaps not too surprising that prices have, once again, begun to fall.
Going forward it is likely that prices will dip further in the months ahead until such time as U.S. producers cut back production which may not occur until prices dip to $45 per barrel or even lower. Furthermore, the peak driving season occurs right around the July 4th holiday and both crude oil and gasoline prices tend to peak at that time of year and then decline between July and December.
OPEC countries agreed to cut back production in December, but despite the cut in OPEC output U.S. production has surged and countered the OPEC decline. As a result, inventory levels in the U.S. and around the globe have continued to climb. That is not a sustainable situation. Production must shrink so that oil stocks drop back into closer alignment with demand. Our sense is that prices will continue to slide until the pain gets so great that producers will ultimately be forced to slash production. What we do not know is when that process will begin. $45? $40? $35? $30?
What all this seems to mean is that the oil market today is vastly different from what it was just a few short years ago. Instead of crude oil trading in a range from $80-110 per barrel, the new range seems to be somewhere between $30-60 per barrel. U.S. production has change the entire industry. And that is a good thing.