Its now been over a year since the 2014 crash in Oil prices from over $100/barrel to current WTI prices of ~$35. Companies have been slashing capital investment plans every quarter (1), major projects are being shelved (2) , (3), (4), the US Rig count peaked around 1930 in September 2014 and currently stands at 709 today (5). Saudi Arabia, the largest oil producing nation in the world has seemingly refused to lower production for fear of once again losing market share to its competitors and despite the cut in rig counts US Oil production has barely budged from its all time high levels of ~9.5mm bbl/day,to ~9.3mm bbl/day(6). Magnus Nysveen of Rystad Energy tries to explain this by making the argument that producers have used 2015 to work through their drilled but uncompleted (DUC) inventory (7). At the same time many domestic producers have held off on hedging “waiting for better prices” while at the same time focusing their production in their best areas while optimizing well completions and driving significant efficiency in their newly drilled wells, all of which is propping up production and limiting their opportunity to drive prices higher.
This has been one of the more interesting case studies since I’ve become involved in the Equity markets. First, the crash caught nearly everyone, including myself off guard. I actually remember saying late last summer (2014) “If oil goes below $85 that must means something has gone terribly wrong in the global economy”. Looking back I couldn’t have been more wrong, though slow global growth contributed to a supply glut, overall global demand for oil never decreased. In retrospect it is easy to see that this was a supply problem, exasperated by the strength of the US Dollar as well as several other factors.
Early on in the ZIRP & QE era the overwhelming belief from fear mongers was that those policies would inevitably result in inflation/hyper inflation as liquidity & easy money started to push more dollars to fewer resources. As such, it is somewhat ironic that one could make a reasonable argument that QE and ZIRP policies played a large role in oversupplying not only the oil and gas markets, but commodity markets in general. Along with the velocity of technological innovation we’ve seen in America’s oil fields this access to cheap capital allowed drillers to vastly increase both the number of wells drilled and the amount of oil/gas extracted from each well.
The biggest lesson I’ve learned from this in general, as it was my first real bear market in a particular industry is that 1) the cycle can go longer and deeper than you would have ever though. Here we stand in December 2015, almost a year and a half after the initial collapse in energy prices with WTI nearly $70 below its highs in 2014. Not only did I never thing oil would never trade with a “3 handle”, but I surely didn’t think it would do it on two separate occasions. My belief in August during the last plunge was that we had probably seen the lows on the year with rig counts dropping here in the US and non-OPEC supply falling.
OPEC, and primarily Saudi Arabia, has played a large roll in the oil collapse as well. They’re currently the largest supplier of OPEC oil and during previous oil price declines had been the country would pull back on supply in order to bring the market back into equilibrium. That has not been the case this time. Simultaneous to this cycle’s decline in oil prices was unfortunate coincidence of oil export sanctions being lifted on Iran, who just so happens to be the sworn enemy of Saudi Arabia. This only exacerbated the Saudi’s desire to continue pumping in order to maintain market share, and weaken their enemy Iran.
At this point it is difficult to know when the scales when the market will return to equilibrium. Many companies, even domestically, have been far too optimistic in their forecasts. Just last week (Dec 9-10) KMI, who was forced to cut their dividend by 75%, gave 2016 guidance forecasting $50 oil. Several other E&Ps have held off on hedging any production in 2016 and publicly stated they’re all “waiting for higher prices”(8). Compounding my concern is the varying information regarding the amount of DUC’s (drilled but uncompleted) wells currently sitting in oil fields across the US. Some estimate that as much as 400,000bbl/day of supply (9) (10) that can come online in a relatively short time frame were oil prices to recover to “reasonable levels”. (Many E&Ps have said they’re looking for sustainable prices in the mid-$60’s)
All of this represents a nearly perfect encapsulation of the economics of operating an energy related business. The “prisoner’s dilema” reigns true in every sense of the analogy. Coming from a family very familiar with dairy farming I should have been more aware of the likely actions early on. My father has always said “when milk prices are bad every farmer thinks all the other farmers should cut their milk production”. If it wasn’t before, it is pretty obvious that belief is not unique to the dairy industry. When hundreds or thousands of producers are selling effectively the same product you’re always going to run into these issues.
Conditions that could lead to a regaining of equilibrium in the oil market:
- DUC inventory does not lead to “cheap” production over the intermediate term
- Credit markets tighten further
- Bankruptcies of marginal producers lead to further curtailment of supplies
- non-OPEC supply continues to dwindle further
- Nations come to their senses and realize that drilling wells with negative returns doesn’t make sense and hold off on drilling un-ecomonic wells
- Prices go so low that even Saudi Arabia can’t withstand them over a sustained period