The downward spiral in global oil prices is only going to get worse, potentially sinking to $20.00 a barrel.
Crude oil seemed to have finally found its bottom this spring, rebounding to $60.00 a barrel and apparently putting the winter nightmare firmly in the rearview mirror. But all of that has been reversed in the last few weeks, as West Texas Intermediate (WTI) prices have sunk to their lowest level in four months, coming within a hair this morning of the March 17 record low of $43.46.
This time there will be no quick rebound, and the pain felt in the oil industry will be greater.
But the prices rebounded a few months ago, so what’s different this time around? Why can’t companies just follow the same strategy as before?
The New Reality
The financial profile of oil companies is much, much worse than it was half a year ago, and market fundamentals are at a profound imbalance.
China and other major emerging economies fuelled a major commodities boom starting around 2004. Today these countries can no longer fuel global demand, as they are dealing with macro imbalances and significant debt loads.
The effects on global markets are plain to see. The Bloomberg Commodity Index, made up of 22 raw materials, saw 18 of those commodities drop by at least 20% in July. (Source: Bloomberg, last accessed August 7, 2015.)
Combine this with the pessimistic view of financial lenders and you have the perfect storm for a massive drop in the price of oil.
Today’s spot prices have reverted back to this winter’s lows. But forward prices have now also plummeted to levels unseen since 2005, effectively wiping out the last decade’s gains. Forward prices for December 2018 are trading at $58.88 per barrel for WTI—the lowest in ten years. (Source: CME Group Data, last accessed August 7, 2015.)
Oil prices are leaning so heavily towards the downside that $20.00 per barrel oil is now a real possibility within the next two years.
The OPEC strategy to ramp up production in an effort to curb that of North American producers has failed.
Rather than cutting down production in response to oil prices, both regular and shale oil producers have instead scaled back exploration and new drilling activities. The flow of oil from them has not only slowed but increased.
Though a significant number of shale producers are seeing their hedging strategy crash and burn with continued slumping oil prices, with bankruptcy imminent for many of them, it won’t stop the tide of production by much. It will simply mean that their production will be acquired by larger competitors who are able to ride out the storm.
How can I put this all into perspective? Saudi Arabia, the world’s largest oil producer, is projected to have a budget deficit equal to 20% of gross domestic product (GDP) this year. (Source: Platts, last accessed August 7, 2015.) Its massive foreign reserves stood at $677 billion in May, down nine percent since August 2014.
The Effect on Oil Producers
Companies are now facing both financial stress and operational difficulties. Re-structuring your revenue model when the value of your primary product declines by half in one year is difficult for any business. But even more so for energy producers that can’t easily cease activities in an economically feasible manner.
You should also be looking for clues in lending markets, which are quite transparent in their lack of confidence in the energy sector. While most banks and financial institutions maintain near-term oil price forecasts of $45.00-$50.00 for WTI, they are nearly unanimous in emphasizing that risks remain substantially skewed to the downside. (Source: Oilprice, last accessed August 7.) This is particularly true for the next quarter, with its historically lower gasoline demand.
Translation: large financial institutions are betting large sums of money on oil prices not rebounding any time soon, and with good reason.
Logistical constraints are much tighter now than they were earlier, thus increasing the chance of hard physical limits (storage) reducing supply.
The latest news to rock crude oil markets is the worrying storage report released by The Goldman Sachs Group, Inc. (NYSE:GS). (Source: Goldman Sachs, last accessed August 7, 2015.) Global oil oversupply stands at over two million barrels per day, and is now threatening world storage capacity.
Approximately 170 million barrels of crude oil and fuel were added to storage tanks and 50 million barrels to floating storage globally since January 2015, according to the Goldman Sachs report. This corroborates Energy Information Administration (EIA) data, which indicates a global oversupply of approximately two million barrels a day. (Source: EIA, last accessed August 7, 2015.)
If global storage capacity is truly tested, and it well might be, the price of crude oil will go into free fall. How low, you ask? Below $40.00 per barrel is likely, but I wouldn’t be surprised to see prices fall as low as $35.00, $25.00, even $20.00.
What can be expected from oil markets in 2016? Much rests on the resilience of broader global markets to current difficulties, but also how macro trends will play out. Economic data is certainly gloomy at the moment.
How can this situation be reversed?
Paradoxically, the longer oil prices remain lower, the better. Only in a period of low oil prices will capital markets stop propping up activities that are perpetuating the supply glut. A market correction in fundamentals will occur only if certain production becomes unprofitable.
Translation: the industry needs to experience prolonged stress in order to rebalance itself. If prices rise, capital markets will open up once again and keep the current status quo going.