Why the Age of Cheap Oil Is Over

The longer I look at what is going on today with oil prices, the less it makes sense to me. I know there are a lot of experts who blame this all on the “glut” of oil created by overly aggressive U.S. upstream companies that took all the cheap money they could get to “drill, baby, drill.” However, the size and speed of the drop doesn’t seem justified when there is still plenty of room to store the short-term oversupply. Last week’s Department of Energy crude oil inventory report shows that we still have plenty of room in the storage tanks. In fact, the DoE reported a draw from storage of more than 3 million barrels for the week ended January 2.

Granted, oil storage levels are running above the previous 5-year average, but with a worldwide “glut” of oil production, why would refiners need to pull oil out of inventory?

There is some truth to the U.S. rapidly increasing oil production eating into Saudi Arabia’s market share, but to say we have some sort of global supply glut that cannot be absorbed by this market is nonsense. Humans are forecast to burn up 34.3 billion barrels of liquid hydrocarbon-based fuels in 2015, so the “glut” argument seems to be quite a stretch to me. Plus, the demand for oil goes up by another 300 million to 400 million barrels each year.

The last time we had a drop in the oil price this large was in mid-2008. Prior to the drop, we saw a rapid run up in the price, which was blamed on the “evil speculators.” The speed of the drop from $147/bbl to $35/bbl was partly because of the huge margin calls the non-commercial traders received. They were forced to cover their long positions when there were no buyers. The recent drop in oil prices has also been exaggerated by margin calls.

Keep in mind that short-covering rallies can occur, as well. Today, non-commercial traders (“speculators”) outnumber commercial traders by around 18-1. The non-commercial traders cannot take the oil or deliver it, so they must cover their open positions before the futures contract expires. What do you think will happen if OPEC announces an “emergency meeting” or Russia and Saudi Arabia announce a joint agreement to cut production? The mood on the NYMEX trading floor can change very quickly.

In its Oil Market Report sent to clients on Thursday, DNB Bank’s Oslo research team, led by oil market analyst Torbjørn Kjus, said, “We now believe prices have dropped to unsustainably low levels and our oil price forecast is now bullish vs the whole forward strip.” Kjus is forecasting a rebound to $70/bbl for Brent during the second half of this year.

Getting back to the topic

Saudi Arabia’s decision on Thanksgiving Day to maintain its production level near 9.7 million barrels per day is costing the country a ton of money. Jefferies Energy Group made a presentation in Houston last week, and it put up a slide that showed the price of oil each OPEC nation requires to balance its budget.

Source: Jefferies Energy Group

Saudi Arabia requires $93/bbl Brent to balance its budget. At today’s oil price, the kingdom is going to watch its savings account drop by an estimated $50 billion this year. We all know Saudi Arabia can afford it; however, all but four OPEC members (Kuwait, Qatar, Saudi Arabia, and the United Arab Emirates) will see their entire sovereign wealth fund wiped out this year if oil prices stay this low. Algeria, Nigeria, and Libya are already broke, and Iran and Venezuela are getting close. I doubt there are a lot of bankers lining up to lend this group any money.

We must keep finding new supplies of oil, because every oil and gas well ever drilled goes into decline shortly after it is completed. Assuming current wells are declining by at least 5%, we need to drill enough wells to increase production by 4.6 million barrels per day each year just to stay even.

The problem is that there are very few places left on Earth where it is economically feasible at today’s oil price to find and develop new supply. Even in the really good parts of the Eagle Ford Shale, you need $52/bbl just to break even. There are not many publicly-traded oil companies that I know of that are in this business just to break even. If all but a few OPEC nations are broke, who is going to drill the wells we need to supply future demand?

Source: Energy Information Administration

What happens now?

Here are my predictions:

  • We are going to see an increase in M&A activity. The majors and well-funded large caps will swoop in to take advantage of the situation to buy up some distressed smaller companies at bargain prices.
  • The active rig count will drop rapidly. U.S. oil production will continue to increase during the first quarter of 2015, slow in the second quarter, and be flat to declining by the third quarter. The combination of a lot fewer new wells with thousands of rapidly declining horizontal shale wells will take care of this supply “glut” in short order.
  • The International Energy Agency (IEA) will raise its global demand forecast, since lower fuel prices will increase demand. Consumers have more money already to spend on more “stuff” and it takes more hydrocarbon based fuels to make and deliver that stuff.
  • The price of oil will rebound before the end of the second quarter. I doubt we will get back to $100/bbl anytime soon, primarily because of the strength of the U.S. dollar. I think we will see WTI over $70/bbl by sometime in the third quarter.
  • Bad News for the “Gassers”: Natural gas prices may test $2/mcf unless we get some very cold weather in the eastern half of the U.S. over the next six weeks.

Very soon, we will be getting a flood of fourth-quarter 2014 results and year-end reserve reports. I will be looking very hard for prime takeover targets, and I suggest you do the same. This should be an interesting and profitable year for energy sector investors.

Originally written for OilPrice.com, a website that focuses on news and analysis on the topics of alternative energy, geopolitics, and oil and gas. OilPrice.com is written for an educated audience that includes investors, fund managers, resource bankers, traders, and energy market professionals around the world.

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