Our company president is fond of saying that one reason he loves being in the oil business is that “it’s always in the news”. This month I was getting emails almost daily from our experts saying, “This news is huge!”
Global oil prices have now dropped over 25% (official bear market territory) due to surging production, uneven global economic growth, and geopolitical factors.
The news is all about how these lower oil prices will play out on the global stage.
Last week I posted a quick heads up about a WSJ article on the economics of oil production here in North America and how lower prices might affect this segment of the industry. When an old friend from the other side of the globe reached out and asked me to send him more, it reminded me that the world is watching.
As a finance guy, I generally read the Journal. And here is a timeline of some of the topics they covered over the last month when I began to notice this theme starting to play out in the news.
Of course, this isn’t a comprehensive list. Some of my papers made their way into the garbage or the kids art projects. Also, some of the links are open to subscribers only. But here we go.
A Busy Month of Oil News
It all starts with a special energy report titled “Why Peak Oil Predictions Haven’t Come True – and Probably Won’t.”
The notion of Peak Oil, popularized in the 1950’s by Shell geologist M. King Hubbard, theorized that US oil production would peak in the 1970’s and decline thereafter. Domestic production did indeed peak in the 1970’s, giving the idea legs in the media and among policy makers.
However, the surge in domestic production do to technical advances such as horizontal drilling, hydraulic fracturing, and deepwater production have led to the new reality that technology will continue to unlock new reserves for the foreseeable future.
But at what cost?
Thomas Friedman writes an op-ed in the New York Times discussing the historical precedence of oil prices as a weapon against oil-dependent economies, in this case Russia and Iran. We all know about recent posturing from Russia including more aggressive military operations and meddling in Ukraine.
Additionally, while sanctions continue to put a strangle hold on the Iranian economy, lower oil prices threaten the budget of this oil-dependent government.
Friedman offers that the price drop from US production, coupled with Saudi Arabia’s decision to protect market share over oil prices, is amounting to a war on the Russian economy similar to that in 1985, which contributed to the collapse of the USSR.
Check out this article I found from 2008. History repeating?
This theme plays out further in a series of articles which include the same cast of characters.
Sound familiar? This scenario seems to play out each year as winter approaches. Russia uses energy as a political weapon, and the the EU, dependent on Gazprom for 39% of its natural gas is forced to the bargaining table.
In the middle is Ukraine, not only in the midst of a near civil war, but home to about half of the pipeline capacity that brings Russia’s gas to the EU. Russia cut gas supplies to Ukraine and the rest of the EU twice in the last decade (2006 and 2009). Both times at the height of winter.
Literally right below the EU/Russia article, the geopolitical effects of oil prices are discussed regarding Iran, militants, and nuclear talks.
Two years of economic sanctions, the rise of Islamic State militants, and now plunging oil prices are major chips forcing Tehran to the negotiating table. Iran is currently dependent on oil revenues for approximately 60% of its budget, and exports have been cut in half by sanctions.
While no major breakthroughs have been made, progress is being made toward a November 24 deadline on the current round of negotiations.
This article highlights some historical reference behind OPEC protecting market share over prices. Saudi Arabia, OPEC’s lowest cost producer, is clearly leading the charge against cuts in production quotas.
Geographical shift to South America and Mexico
A couple of articles highlight how lower prices are impacting Venezuela, Brazil and Mexico.
The recent change in Mexico’s constitution has the global industry buzzing with the possible awakening of a sleeping oil and gas giant. While Mexico’s geographic location relative to the US is a huge advantage over regional and global rivals (namely Brazil), it does have some catching up to do.
Additionally, much of Mexico’s reserves lie in the deepwater Gulf of Mexico, and this is where global prices come into play. This is technologically difficult and expensive oil to recover.
Falling Oil Hits Ailing Venezuela
The price for heavy Venezuelan crude is already below $80. For this oil revenue dependent economy, this is beginning to spell trouble.
This article points out that default concerns for both the government, with $35 billion in external debt, and PDVSA, with another $32 billion in debt, have pushed yields on Venezuela’s benchmark bonds past 18%.
Economist David Rees states, “There is a clear risk that the authorities will run out of money.”
Petrobras’s Worries Keep Building (October 28)
Since September 2, Petrobras’ market value has fallen by $69 billion. Morgan Stanley estimates that marginal costs on Brazilian fields range from around $75 a barrel to above $100.
News Turns to Refining
As October wound to a close, the news related to refining began to heat up.
On the surface, falling oil prices tend to be a boon to refineries as the cost of their main input decreases.
But it’s time the demand side of the economic equation received some attention. At a certain point, concerns over global demand for products can come into play.
One article noted that the Gulf Coast crack spread has collapsed from almost $16 to about $5.50 since October 1 even as the price of crude has fallen by $10.
Falling Oil Prices Hang Over Refiners
How much of the global oil glut can be attributed to economic weakness in China and the EU?
As news of massive stimulus from Japan hits the markets, global players are forced to consider whether the US is the only major economy on solid footing and whether that is enough to soak up all of the product floating around.
This article explores the relationship between prices in the US and Europe. The difference between benchmark crudes in the US and Europe (the ‘arb’) has narrowed from $19 to $5 over the last year, wiping out most of the cost advantage domestic refiners have enjoyed against global competitors.
Gas at $3 Carries Rewards and Risk
Lower energy prices are a boon to consumers. There is no doubt about it. One rule of thumb is that “every one-cent drop in energy prices is worth $1 billion in annual household consumption nationwide.”
Families are benefiting from sub-$3 gasoline and the prospect of lower heating bills going into winter.
The flip-side of this coin is that these prices could slow one of the nation’s hottest sectors and creep into the broader economy.
Wall St. Throws in the Towel
A 25% drop in crude prices force an about-face by analysts across Wall Street. Bank analysts, led by Goldman Sachs, are capitulating on bullish calls in the face of global headwinds to crude prices.
So why were all these smart economists and analysts caught off guard?
On the supply side – a resurgence of production from Libya and resilience of Iraqi production despite unrest. Additionally, an assumption that OPEC would work to protect prices has proven misguided.
On the demand side – economic weakness in China and the EU.
So now for the big question!
Can the US oil boom withstand prices at current, or even lower, levels?
If you were to just read the headline of this recent article, you might think so. However, as you dig deeper you realize that perhaps there is more to the question.
The article “Energy Boom Can Withstand Steeper Oil-Price Drop,” perhaps should be titled “Energy Producers can Withstand a Bit More of a Drop”.
The article offers an in depth description of the small to midsize energy companies that dominate the domestic production boom. Some of these companies have taken on substantial debt loads, which was fine at $100 or more a barrel.
This article also provides a great synopsis of the economic ranges of different producing regions in the US.
The bottom line seems to be that with crude prices above $80 production remains economical across most regions, but we’re getting toward the tipping point. Below $75 and things start getting interesting.
For more on oil prices visit Oil Prices Daily.
Related Article: Upstream vs. Downstream