Crude oil entered a bear market in 2015, and investment banks are scrambling to see who can go lower in their forecast for a price bottom.
During the 1998 Asian financial crisis, crude plunged to $10 per barrel, and there are many examples of booms and busts over the last several decades. The current bust was driven in part by new drilling technologies that flooded the world in a surfeit of oil at a time when world economic growth slowed to a crawl following the 2008 financial implosion. The prospects for a return to an oil price boom in 2016 do not look good.
Massive Oil Glut
The oil glut is so extreme that the chairman of a major oil company recently said he would soon be filling swimming pools with crude oil. New and better shale fracking technologies, especially in the United States, are responsible for the ocean of oil that the industry now ironically perceives as a problem. The U.S. Gulf Coast is bloated with inventories, and the need for more storage space is growing.
Cushing, Oklahoma, calls itself the pipeline crossroads of the world and is the delivery point for physical settlement of the Chicago Mercantile Exchange’s crude oil futures contract. Huge amounts of crude oil are stored there, and it is almost out of space. The situation is so extreme that the costly option of floating storage in the Gulf of Mexico is now increasingly utilized. Floating storage is only economical when the oil market goes into super-contango, where prices for oil delivery in the future are much higher than current prices. This is the condition of the market in early 2016.
Exacerbating the oil glut is the cutback in demand from refineries, where gasoline profits are shrinking. Finally, several of the lower-fixed-cost shale fracking companies in West Texas continue to make money even with crude oil under $30, so there is no incentive for them to curtail production. The only question left for the industry is where to put inventories when off-shore tankers and swimming pools are completely filled up.
Higher Crude Price Will Activate Idle Wells
Even with crude oil near the bottom of its descent, shale fracking companies experiment with new techniques to extract more oil from the ground. Goldman Sachs analysts have been very accurate regarding the direction of oil’s price, and they forecast a price that may dip to $20 or below, finally forcing the lowest-cost shale drillers to the sideline. If that forecast is wrong and oil rebounds to $40 or more, there will be a frenetic scramble to open new shale fracking locations, throwing more oil into the glut and keeping a lid on price.
Apart from shale fracking, oil companies keep drilling new deep wells. Today there are over 4,000 idled wells in the United States, and they will be brought into production if the industry perceives a firm bottom in the crude oil bear market. The process of limiting oil’s price ascent is the same no matter the source of the oil, and production will continue to outpace demand in a world still experiencing uninspiring economic growth.
OPEC Promises to Limit Production Not Trustworthy
Saudi Arabia wanted cheap oil as a weapon to drive shale frackers in the United States out of business, but oil prices are now too low for OPEC, a liquid prison they want to break free from. It is true that Saudi Arabia has hurt the shale fracking industry, but it is far from destroyed. Saudi Arabia’s grand bargain with Russia seeks to freeze production and lift crude oil, but it is built on bluster and false promises that will never work. Past OPEC agreements to limit production were always undermined by cheating among the members who could not adhere to production quotas.
Each member country has different economic issues that require sustained oil revenue to keep budgets afloat and citizens employed. The premise of a higher oil price and increased revenue based on idle pumps sounds good on paper, but OPEC members don’t believe it. If they did, members wouldn’t demand special exemptions every time a production freeze is proposed. Moreover, Iran has finally reached a point where it is able to run its oil fields full-tilt and is unlikely to adhere to an agreement. Russia is not trustworthy either, so the grand bargain to freeze production will amount to nothing.
No Place for Crude Oil Bulls
Oil bulls are likely to endure continued crude oil malaise in 2016 because there are no rational reasons why it should end. There is too much oil and no strong incentive among interested parties to find a way to do anything about it. The long-time industry axiom that the cure for low oil prices is low prices is broken if underlying conditions do not change.
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