Don’t bet on oil prices getting back above $70 a barrel

Oil has had a tough week. The price has fallen for six trading sessions in a row, with the key US benchmark – WTI – falling below $50 a barrel late last week.

The price of Brent crude – the European benchmark – has fallen by around 10% since late last year.

This is all despite the best efforts of oil cartel Opec and big producer Russia to cut production and drive prices higher.

So what’s going on? And what’s next for the oil market?

The shale revolution may have capped oil prices

As regular readers will know, US shale oil has been the big “disruptor” in the oil market.

Prices were so high for so long, that it made economic sense for US shale producers to get busy with hydraulic fracturing (“fracking”). The US went from being a spent force in the oil market to being a huge global player once again.

As supply rose and investment in shale producers grew, oil prices started to fall. Rather than slash supply, Saudi Arabia and other Opec members responded by pumping and selling even more oil, much in the same way that supermarkets will slash prices when competing with each other for business.

That didn’t work. US producers rode out the collapse in prices. The oil majors had to abandon ambitious expansion projects and prioritise dividend payouts. Shale producers, meanwhile, had to stop exploring, and cut back on deployment of drilling rigs. But they survived, helped partly by loose monetary policy and forgiving covenants.

Opec finally gave up and promised production cuts. Prices bounced. But this is where the really disruptive aspect of shale comes into play.

Shale production has always been viewed as easier to “turn off and on” than many other traditional forms of oil production. And that does seem to be the case.

Allen Brooks of specialist energy investment bank PPHB makes a very interesting point in his latest piece on the oil industry. It seems that “the worst downturn in the history of the oil industry has been followed by the fastest drilling rig recovery in history”. (Or at least as far back as 1968, which is ancient history in oil industry terms.)

Brooks compares previous oil slumps and recoveries with today’s. Oil prices hit a panic trough near the start of 2016, then began to rally. Over the course of the past 12 months, the rig count has more than doubled (in other words, oil producers got pumping again quickly). The recovery of 2009 (after prices cratered in 2008) took almost two and a half years to get to that point.

Shale producers have been able to continue making money at current oil prices due to two things: technological improvements; and a sharp fall in the cost of oilfield services.

Brooks notes that most analysts reckon 60%-70% of cost savings derive from technology, with the rest coming from a drop in oilfield services costs. Of course, as demand from oil companies rises, prices for oilfield services will rise again too.

At that sort of split, if you assume that oilfield services companies claw back all of the cost savings made by producers and explorers by the end of 2018, then – at $55 a barrel of oil – explorers face “significant reductions in profitability”, notes Brooks.

So on the one hand, you can see that some shale producers might have to turn cautious again if prices drop much below where they are now. On the other hand, it’s also hard to see prices rising much above where they are now either, given the ability to respond rapidly with new supplies.

Why we should be happy about lower oil prices

From an investment point of view, I do struggle to get excited about the oil sector at the moment. The big recovery gains have largely happened. That’s not to say there’s no value in the sector or that there aren’t any long-term buys – just that the bargains have been rifled out of the bin pretty rapidly.

If the oil price has another major downswing, then it could get interesting again. I wouldn’t rule that out, but right now it’s not my base-case scenario.

However, stepping away from the oil market for a moment – looking at the bigger picture, it’s always worth remembering that falling oil prices are a good thing for most of us in the West.

We are all energy consumers. So unless your livelihood depends on oil production (a significant and important minority of UK and US workers, but a minority nonetheless), then falling oil prices shouldn’t be overly troubling. In fact, they should give you a bit more money in your pocket.

The world’s central bankers and politicians might be arguing that they want inflation, but if that inflation is driven by the price of necessities going up, then it’s not very helpful. You might as well slap another 10% on VAT and call that inflation.

A drop in oil prices acts more like a tax cut. It’s not a huge amount of money, but every little helps. I think it’s fair to say that the oil price collapse of the last few years has been pretty helpful for Western economies in general, helping to prop up consumption in the absence of rapidly rising wages.

Meanwhile, the benefits we reaped from high oil prices – increased investment in renewable energy, the development of US shale resources, and the evolution of electric cars – are now firmly entrenched.

Lower oil prices might not help the case for electric cars, for example, but it’s hard to see their development being entirely derailed. Particularly as car manufacturers might be starting to realise that the best way to create an entirely new upgrade cycle would be to reinvent the car altogether, and start lobbying governments for fossil-fuel scrappage schemes.

Anyway, to return to the point – a stable-ish to slightly lower oil price is probably just what the world could do with right now. Whether we’ll get it is another matter.

  • Paola Crawford

    but how do you see the diminishing EROI (Energy Return on Investment) on oil playing out? How long before it’s just not feasible for a company (Exon etc) to only pull 5-10 barrels out for every one barrel used to extract it? Hasn’t Exon been showing large debt 2016?

    • John Symons

      When it comes down to it it is the net cash flow of an oil field and the resulting cash rate of return that counts, in particular whether and by how much it exceeds the company’s after tax weighted average cost of capital. The costs of all inputs are important, not just energy. I see no reason to be concerned about the situation you paint of energy forming up to 10-20% of an oil company’s costs. Many other industries have a much higher energy component of cost. Take aluminium production, for example. There is no direct connection between EROI and debt. Exxon’s debt is the result of its business decisions and its business environment.

  • Peter Edwards

    Who cares about oil, its on death warning like Coal.

    As Ahmed Zaki Yamani Said “The Stone Age didn’t end because we ran out of stones.”

    It will end because Solar power is compounding.

    • John Symons

      The compound growth rate of solar power cannot continue indefinitely until a commercial energy storage system is invented, developed and actually bought (remember nuclear fusion?) that can turn intermittent solar and wind power into effective baseload generation. A minimum amount of power has to be available all the time, through night, cloudy and windless periods. Coal should be on a bigger “death warning” than oil, and oil than gas, because of their relative CO2 generation per unit of heat generated when they are burned. Try telling that to President Trump, though.

      • Peter Edwards

        I’m with Trump on this one too, but not for the same reasons.

        I don’t doubt that Global Warming is a real phenomena and it would cause damage, but those end of century projections are laughable renewable energy will be near 100% energy use well before end of century, my guess is that we will hit it before 2050.

        Storing energy is an easy task we just have local batteries and or long distance electricity transmission.

        • jaizan

          Storing a little energy is easy. However, when we have a cold spell in the winter with almost no wind for a week or so, we would need to store an obscene amount of energy.

          Also, even across the UK, we get periods where wind output is running at about 1% of capacity in winter. Nobody has demonstrated how these renewables will properly replace fossil fuels.

  • John Symons

    An excellent article. There is far too much doom and gloom about low oil prices in net oil importing countries like the UK and the USA. They do act like a tax cut for the whole national economy and they benefit the downstream (refining and chemicals) side of the oil industry. If such a country wishes it can use taxes and subsidies to redistribute just part of the the benefits in order to protect its oil producers.

  • Michael Bronislav

    found this another interesting article The Last of Oil and Gas: Do we still have enough? new reserves are found but we consume almost 31 billion barrels of oil per year and can be multiply soon, whatever happen to the oil prices one thing is for sure, fossil fuel age isn’t ending soon….