February 18, 2015
Since the beginning of February, the price of Brent crude has gone up by nearly USD 10 per barrel. Analysts agree that the recent price hike was driven primarily by data published by Baker Hughes, a U.S. oilfield services company, reporting a massive fall in the onshore drilling rig count – down 259 in January. It was the biggest plunge for U.S. oil rigs since 1987, leaving only 1,223 active units, the lowest count since 2012. To compare, throughout 2014 the average onshore oil rig count reached 1,527, peaking at 1,609 in the week ending on October 10th 2014. But in January, the month-end drilling rig count dropped 24% on the record-high mid-October count. Without a doubt, the oil rig count plunge was driven by the tumbling crude oil prices, and what we are now witnessing is the curtailing of U.S. production capacities. Does this mean that the recent oil price rise observed since February marks an end to the fourth price-slump phase in the oil mega-cycle and heralds an upward trend, as many analysts are tempted to believe?
There is no way of knowing how long the oil price spike will last, but I am convinced there is still a long way to go before we reach an end of the current price collapse, and we will see major price fluctuations along the way until the market finally learns how to read the signals coming from that unique oil production segment, namely the U.S. shale oil (commonly known as ‘tight oil’). In this case, a simple comparison with conventional oil production will generally lead us to wrong conclusions. For one, it would suggest that the falling drilling rig count signals a corresponding decline in production. Indeed, the financial markets seem to have fallen for it, which sparked the crude price hike not driven by any developments on the supply side. The U.S. market has seen the first efforts to prop up the oil prices with the marginal cost of oil production, fully supported by the stock exchange and financial transactions on the futures markets. The greater involvement of financial institutions in the financing of shale oil production compared with conventional projects may be explained by the fact that U.S. is home to the world’s most developed financial market, and also by the specific nature of the U.S. oil industry with a high share of independent operators financing their exploration with borrowings. Therefore, we can expect high volatility of crude oil prices and their sensitivity to any information which may affect the supply side (including geopolitical factors and production capacity).
Let us now take a closer look at this. Baker Hughes’ data shows that the average number of wells per rig in 2014 was more than 20, but the actual number of wells on a field ranged from 10 (Utica) to as many as 60 (Fayetteville). But wells differ, too; some yield below 100 barrels a day, others 800 and more. As a result, the cost of producing a barrel of oil varies greatly between wells (given that more than 37,000 wells were drilled in 2014 alone!), and the discrepancies are even more pronounced if we compare different rigs. Secondly, oil is produced both by petroleum giants and by independent operators; the latter usually using borrowed funds to drill in new licence areas, bearing the entire risk, and selling their licences to larger companies at a healthy profit when a well turns out to be productive. But they are the first to bear the brunt of falling crude oil prices. Independent operators usually curtail or discontinue production due to difficulties in securing the necessary funds, as financial institutions react to price slides. In contrast, large oil companies have their own funds to finance drilling and are more creditworthy. Given a multitude of new wells being drilled and considerable asymmetry of the marginal cost of oil production, as well as reactions of oil companies to price trends (based on the availability of financing), the mere decline in the drilling rig count does not mean that production will follow a downward trend, too. For this to become a reality, the crude prices would need to stay low for at least several quarters.
The recent oil price spike, spurred by the misinterpreted information on a decline in the oil rig count, diverted the expected oil price trend from flat to rising, thereby extending the time horizon for unavoidable correction. When planning new wells, oil companies never focus on today’s (spot) prices but rather on estimated prices from the moment a well starts producing for the subsequent 1.5-2 years (when a well’s yield is at its highest, falling sharply afterwards). On the other hand, lending institutions always look at spot prices as a source of their cash inflows; if today’s oil prices are rising, they will be more willing to advance credit to finance new wells. As a reminder, the shale field investment cycle (from the start of drilling until the first barrel of oil is sold) lasts only 90 days; bearing this in mind, a price increase of USD 10 per barrel since the beginning of February has inevitably driven a rise in the well count and in future production volumes compared with a scenario involving flat or declining oil prices.
Other factors might also have contributed to the recent price increase. For one, the easiest way to handle crude oil produced from a field is to put it in storage. To make the storage of crude oil commercially viable, the spot price must be lower than the 3- or 6-month futures price; such a situation on the oil market is called ‘contango’. Therefore, the spot price slid to create a sufficiently steep contango to accommodate the cost of oil storage and associated profits. Buying oil to keep it in storage will drive temporary demand, which may lead to an increase in spot prices, if the storage premium was too high to start with. Still, oil storage alone is not a sufficient remedy for a supply glut. In the end, the stored oil volumes must be converted into fuel, which must be consumed. This process will take time, and an increase in fuel stocks along the way, driven by fuel prices, will keep the crude prices from rising.
So, what about the outlook for crude oil prices? First of all, we can expect strong price volatility and it may take long for a clear trend to emerge and settle. According to Anatole Kaletsky, a distinguished economist, the oil price will hover between USD 20 and USD 50 per barrel for many quarters to come, necessary to curtail the production capacity and create a market equilibrium. However, it will not stay below USD 20 per barrel for too long, this being the lowest known marginal cost of oil production in Saudi Arabia. On the other hand, a price rebound above USD 50 per barrel will trigger U.S. production and, consequently, drive the price back down. Jim O’Neil, another prominent economist focusing on commodity markets, believes that five years from now crude oil will be sold at USD 80 per barrel, at today’s futures price, and the prices will soon start a slow ascent. As a result, at this year’s end they will be higher than at the beginning. Indeed, the two forecasts are not contradictory and fit well within our understanding of the oil market reality.