The Problem With Oil Prices Is That They Are Not Low Enough

The problem with oil prices is that they are not low enough.

Current oil prices are simply not low enough to stop over-production. Unless external investment capital is curtailed and producers learn to live within cash flow, a production surplus and low oil prices will persist for years.

Energy Is The Economy

GDP (gross domestic product) correlates empirically with oil prices (Figure 1). GDP increases when oil prices are low or falling; GDP is flat when oil prices are high or rising (GDP and oil price in the figure are in August 2015 dollars).


Figure 1. U.S. GDP and WTI oil price. GDP and WTI are in August 2015 dollars. Note: I use WTI prices because Brent pricing did not exist before the 1970s.
Source: U.S. Bureau of Labor Statistics, The World Bank, EIA and Labyrinth Consulting Services, Inc.

This is because global economic output is highly sensitive to the cost and availability of energy resources (it is also sensitive to debt). Liquid fuels-gasoline, diesel and jet fuel-power most worldwide transport of materials, and electricity from coal and natural gas powers most manufacturing. When energy prices are high, profit margins are lower and economic output and growth slows, and vice versa.

Because oil prices were high in the 4 years before September 2014 and the subsequent oil-price collapse, GDP was flat and economic growth was slow. That, along with high government, corporate and household debt loads, is the main reason why the post-2008 recession has been so persistent and difficult to correct through monetary policy.

Why Oil Prices Were High 2010-2014 and Why They Are Low Today

Brent oil prices exceeded $90 per barrel (August 2015 dollars) for 46 months from November 2010 until September 2014 (Figure 2). This was the longest period of high oil prices in history. Prolonged high prices made tight oil, ultra-deep water oil and oil-sand development feasible. Over-investment and subsequent over-production of expensive oil contributed to the global liquids surplus that caused oil prices to collapse beginning in September 2014.

Figure 2. Brent price in 2015 dollars and world liquids production deficit or surplus.
Source: EIA, U.S., U.S. Bureau of Labor Statistics and Labyrinth Consulting Services, Inc.

Oil prices were high during during the 4 years before prices collapsed because world liquids production deficits dominated the oil markets. This was due mostly to ongoing politically-driven supply interruptions in Libya, Iran, and Sudan beginning in 2011. The easing of tensions particularly in Libya after 2013 along with increasing volumes of tight and other expensive oil led to a production surplus by early 2014 (Figure 3). Before January 2014, supply was less than consumption but afterward, supply was greater than consumption.


Figure 3. World liquids supply and consumption, and Brent crude oil price.
Source: EIA and Labyrinth Consulting Services, Inc.

The global production surplus has persisted for 21 months and supply is still 1.2 million barrels per day more than consumption. This is the main cause of low oil prices that began in mid-2014.

Why Over-Production Continues

Actions taken by the U.S. Federal Reserve Bank to stimulate the economy after the Financial Crisis in 2008 were partly responsible for high oil prices and for the over-production of tight oil in the U.S. that eventually caused oil prices to collapse in 2014.

The U.S. central bank lowered the Federal Funds Rate-the interest that it charges for loans to commercial banks-from approximately 5.5% before the 2008 collapse to 0.2% in late 2008 (Figure 4). By mid-2014, the rate had dropped below 0.1%.


Figure 4. U.S. Federal Funds interest rates, M1 money supply and CPI-adjusted WTI crude oil prices.
Source: EIA, U.S. Bureau of Labor Statistics, U.S. Federal Reserve System and Labyrinth Consulting Services, Inc.

At the same time, the Federal Reserve Bank increased the U.S. money supply (Figure 4) from about $1.4 trillion before the 2008 collapse to more than $3 trillion today as part of a policy called Quantitative Easing (QE). QE involved creating money to buy U.S. Treasury bonds. This lowered the yield that these bonds paid and forced investors into riskier investments like the stock market and U.S. exploration and production (E&P) company bonds and secondary share offerings.

There is a negative correlation between the value of the U.S. dollar relative to other currencies and oil prices (Figure 5). When the U.S. dollar is strong, oil prices generally fall and vice versa chiefly because worldwide oil commodity trades are denominated in dollars.


Figure 5. U.S. trade-weighted dollar value and CPI-adjusted Brent crude oil prices.
Source: EIA, U.S. Bureau of Labor Statistics, U.S. Federal Reserve System and Labyrinth Consulting Services, Inc.

Quantitative Easing, the increase in the U.S. money supply and artificially low interest rates resulted in a weaker U.S. dollar that was a contributing factor to higher oil prices after 2008 (an OPEC production cut in early 2009 was another important factor). The end of QE in mid-2014 and a resulting stronger U.S. dollar corresponded with the collapse in world oil prices (Figure 5).

The relationship between interest rates, money supply, the strength of the dollar and oil prices is complicated and I do not mean to over-simplify its complexity. The observed patterns are, nevertheless, interesting and useful for understanding the broad trends of the last several years at least on a high level.

The net effect of all of these monetary policies was to undermine conventional, passive investments-savings accounts, CDs, U.S. Treasury bonds, etc.-because of low yields (1- 2.5%). Investors were driven to the U.S. E&P sector where high-yield ('junk') bonds and secondary share offerings provide yields of 6-10%. These investments are based on a coupon payment or dividend and not on the company's success unless, of course, the company goes bankrupt.

This and other risks are rationalized by the fact that the investments are in the fiscally 'safe' United States, are backed by a hard asset-oil and gas-in the ground, and that even if a company becomes distressed, it will likely be bought and the investment preserved.

More than $61 billion has flowed to North American E&P companies so far in 2015 both as equity and debt (Figure 6). This is more than in any previous year despite low oil prices, plunging stock prices and poor financial performance for most E&P companies.

Figure 6. Private equity capital directed to North American energy companies.
Source: Wall Street Journal (September 3, 2015) and Bloomberg Businessweek (October 15, 2015).

The only expectation from the financial markets is apparently that production and reserves grow or are at least maintained.

A weak global economy, the monetary policies that were used to strengthen it, and world geopolitical events combined to produce a surge in expensive oil production that was made possible by high oil prices and almost infinite access to capital by producers.

Now that oil prices have fallen by half, many expected that production would fall sharply.

That has not happened because capital supply has not fallen with lower prices but has increased. To be sure, U.S. production has declined and will decrease further. EIA's forecast (Figure 7) suggests that it will fall approximately 940,000 bopd from its peak in April 2015.


Figure 7. EIA crude oil production and forecast.
Source: EIA and Labyrinth Consulting Services, Inc.

The U.S., however, is not the world and less than a million barrels per day of lower U.S. oil production will not make much of a difference in the global surplus. Although world production has declined somewhat, it is still 850,000 bpd higher than its 2014 peak and a supply surplus persists (Figure 8).


Figure 8. World liquids production, consumption and production surplus or deficit.
Source: EIA and Labyrinth Consulting Services, Inc.

Global producers are similar to their U.S. counterparts. Most of them must also satisfy investor expectations, have considerable access to capital, must maintain cash flow, even at a loss, to service debt, and have benefited from greatly reduced oil field service costs that accompany lower oil prices.

The Problem With Oil Prices Is That They Are Not Low Enough

Brent international oil prices have averaged more than $55 per barrel ($51 for WTI) in 2015. As long as prices remain in that range, I doubt that production will fall enough to balance the market for several years or more barring a surge in demand or renewed supply interruptions.

Figure 9 shows that the long-term average oil price (1950-2015) is $45 per barrel in August 2015 dollars.


Figure 9. WTI oil prices in August 2015 dollars, January 1950 - August 2015.
Source: EIA, U.S. Bureau of Labor Statistics and Labyrinth Consulting Services, Inc.

Before the Arab Oil Embargo (1973-74) and the beginning of the Iran-Iraq War (1980), the average price was $23 per barrel. In the 1986 to 2003 period after these oil shocks and before the Financial Collapse, prices averaged $34 per barrel.

These prices seem quite low from our sticker-shocked perspective of the early 21st century, yet oil companies made profits when prices were $15 to $25 real dollars per barrel less than they are today. More importantly, those periods of low oil prices were also times of economic growth and prosperity (Figure 1), whereas the intervening periods of higher oil prices were times of low economic growth.

Capital will continue to flow to E&P companies as long as high yields on bonds and secondary share offerings are paid. Sustained oil prices in the $30-40 range would create sufficient distress among high-cost zombie producers to cause defaults on those offerings. This alone will stop the capital enablers-the investment banks-from directing funds to the E&P sector.

Many believe that the upcoming credit re-determinations and year-end reserve write-downs will greatly limit available capital, and that this will lead to oil market balance. I hope that they are right. I suspect, however, that the capital enablers will stay the course despite higher risks simply because they are unable to identify alternative investments that offer a comparable yield.

Some like OPEC and Wood Mackenzie believe that demand growth will balance the oil market. I also hope that they are right. Others, however, like the IEA take a more pessimistic view because of a weak global economy. The IEA's view of the economy seems sound to me and I am, therefore, doubtful that demand growth will balance the market.

Still others are hopeful that OPEC will cut production and that will balance the market. I don't believe that will happen. A production cut would accomplish little except perhaps for a short-term increase in prices that would result in higher cash flows and a rebound in drilling activity-in short, it would compound the problem of over-supply.

The only way to achieve oil market balance is for prices to go low enough for long enough to stop the flow of external capital to the producers and to force them to live within cash flow. The intriguing aspect of this proposition is the possibility of a return to economic growth that has so far eluded the best efforts of central bankers and economists.


Source: http://www.oilvoice.com/n/The-Problem-With-Oil-Prices-Is-That-They-Are-Not-Low-Enough/a42a7c59c41d.aspx