Saudi Arabia’s Energy Minister Khalid Al-Falih said Monday that he is optimistic about reaching a deal given the interest expressed by both OPEC and non-OPEC members (particularly Russia). In fact, he was so optimistic that he indicated prices could recover to as high as $60.00 per barrel by the end of 2016.
I think it is interesting that the CEO of Apache, in the Q2 earnings call, also called $60.00 per barrel by end of 2016, and a chorus of other CEO’s called bottom or said they were close to calling bottom.
But my question is: so what? What happens then? Well, we have already seen the rig count slowly rising again. The rig count was at 316 on May 27, 2016, but has subsequently been working its way back up standing last week at 428. Obviously, this is still well below the 1578 working on November 14, 2014. But it is a rise of over 100 rigs and that is not insignificant.
Apache has said oil at $60.00 causes them to add rigs. And clearly, some companies have already started doing so. Others are making predictions that $60 a barrel might be sufficient to drive North American production. “We may well see, in a short period of time, strong production growth coming from North America and elsewhere,” IEA Executive Director Fatih Birol said Tuesday in a Bloomberg TV interview with Manus Cranny and Anna Edwards. “Prices around $60 would be sufficient.” This appears to be in line with some analysts that concur – saying that $60 a barrel may be enough for the U.S. to add back nearly a million barrels of production per day from shale plays.
And I agree with them. But this prediction is hard to make. The first problem comes that we, as Americans, tend to assume normal market forces are in play. With oil, they are not. Historically, Saudi Arabia has been the game changer, and until recently had the undisputed title as one of the worlds cheapest producers. So when we analyze, we never tend to analyze the real question: what happens in monopolistic or oligarchic market places? These questions were raised by Forbes, and I largely concur with their analysis.
Generally, monopolies or oligarchies rely on no one being able to compete with them. Each member of the cartel (in this case OPEC) has an interest to cheat so long as no one cheats too much. And this is how production deals have typically worked – at least some members cheat. But as long as the cheating was not too bad, prices would respond through restricted output.
And it would have worked that way this time, but along came fracking. So the battle is no longer simply conventional driller vs conventional driller, but rather conventional driller vs frackers. And these are two different economic models.
Conventional drilling is hugely expensive, is often planned well ahead of time, and production lasts a long time. Much of the cost is the original development of the field and operating cost is a fraction of the total once the well is up and running. Traditionally, this has made oil somewhat inelastic in terms of supply matching demand. That is because we all keep using electricity and driving cars – so producers know their projects are going to last years and years. They are not as worried about lower pricing.
But fracking is radically different. As Mr. Worstall explains in Forbes, “Fracking has an entirely different economic model. Capital costs are low–$5 to $10 million to get a well up and running. Such a well doesn’t produce for decades either, production falls off very quickly to a dribble after a year or two. Really, we would therefore think of fracking as having all of the costs in the current operating costs. Not quite but that’s the mental model to have.”
That means that unlike conventional oil, when the oil prices goes over the fracking operating costs, wells can and will be brought online quickly, perhaps within a few months.
As Mr. Worstall further explains, “So, now we have a source of oil that has high elasticity of supply relative to price. And that really does change things. It means that the days of great soaring prices are gone. Gone for any length of time that is. Sure, fracking isn’t going to supply all the oil for everyone–but oil is fungible, it’s a commodity, so the price is set by the marginal supply and demand not the average.”
So, despite the effect of a potential OPEC freeze, the fact that the fundamental economics have shifted – that is, the price of oil is no longer just driven by supply, but rather, the marginal cost of new production, and I think you have a market with a much more limited upside. If Shell can make money fracking at $40.00 a barrel, the only way they do not do it is if they perceive the future value of the reserves to be more than their carrying costs of the asset or if they perceive the market will turn quickly below their fracking costs over the very short life (compared to conventional production) of the well. Otherwise, they will frack every day.
At the end of the day, I believe this fundamental economic shift will alter our business forever. I believe that the days of radical shifts from $140 to $40 and then back again are probably over. And I fear that if a deal is reached, and U.S. producers jump back in too quickly, we will face the same crises all over again.
This is particularly true if we have not seen stockpiles decrease at a sufficient volume to allow any excess production to find a home. I believe the estimates of needing to burn off 150 million barrels or more from storage prior to a true recovery is probably correct. And while I certainly am feeling the pain of an awful market, I hope that $60 a barrel spurs some recovery, but not a gangbusters style recovery – because if that happens, I think we will all be in for two more years of misery after the initial flury.
By: Ty Chapman
Five Star Metals, Inc.
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