Oil prices continue to drop this week, with no sign of improvement on the horizon.
It’s going to get worse before it gets better, and there are two simple reasons. They’re called supply and demand; with too much of the former and not enough of the latter.
Record production in North American regions such as Texas, OPEC production showing no signs of abating, and the notion of an unshackled Iran is making everyone queasy. Add slumping Chinese oil demand to the mix and you have the recipe for a prolonged low-price environment.
OPEC appears to have produced more oil in July than in June, despite the dramatic fall in prices. The July Short-Term Energy Outlook by the EIA shows the supply of oil continuing to outpace demand by an alarming 2.2 million barrels per day in the first half of 2015. And it’s only forecasted to drop to 1.5 million by the end of this year.
You can expect things to get even worse, as summer driving season will soon be over, and with it the higher demand for gasoline.
But why do individual countries and companies continue to fall over themselves to maximize production? Doesn’t it hurt them by keeping prices low?
It’s rather simple, really. The cost of oil production is the highest in the up-front expenses, mostly to do with finding and setting up a well, after which the cost of extracting crude is relatively inexpensive. As individual companies have no ability to affect price by lowering their own yield, in a low-price environment the only sensible option is to maximize profits by pumping out and selling as much as possible.
Think about it; you’re a business owner whose revenue model is based on selling a product, but its price is falling by the day. You can’t stop production on existing extraction or you will stop the cash flow, so you might as well sell as much of it as possible before the value of your stockpile loses even more value. Now imagine thousands of such producers, all working according to the same logic.
The low prices are shrinking your profit margin and you need to take out loans to keep your operation going. No problem, you’ll keep extracting and making enough money to service your debt. The price will rise before this strategy of yours becomes unworkable. Hopefully, maybe. You really have no other choice here.
The only part of the equation affected by a prolonged low-price environment is capital expenditure; as exploring, finding, and setting up new wells does not make sense at this point. But existing ones need to be worked at maximum capacity to keep the creditors at bay.
Oil markets are currently caught in a vicious deflationary price spiral, where price declines are becoming self-reinforcing due to how they affect producers’ behavior.
When will this process stop? When firms either decide it’s no longer economical to produce, or they go bankrupt trying to kick the financial can down the road. Even the largest oil majors are facing catastrophic declines in profit. And it’s only a matter of time before the market corrects itself.
A great many market players relied on their complicated hedging strategies to ride out low prices, betting on them rising by now. They haven’t. And the number of companies exposed is growing by the day.
What does this mean for the individual investor? Find yourself oil stocks capable of surviving over the next two to three years on minimal profit margins, who haven’t exposed themselves to toxic levels of debt in a half-brained hedging strategy, and with clean balance sheets.
Market fundamentals are an inescapable part of the oil and gas sector. What we are seeing is the calm before the storm. Most producers are now digging in for the final leg of this production race in an effort to see who will be left standing once the dust settles.
Translation: not only will prices not rise this year, but they will continue to drop.
It’s more than likely that we will see the price of oil dip to the low $40.00s, perhaps even the $30.00s, by the end of 2015.