December 14, 2015 § 1 Comment

Crude oil prices reached $36 per barrel this week. I had opined in a previous post in April that oil prices would fluctuate in a saw tooth pattern. Well, that has come to pass after a fashion, but not quite in the way I thought it would. First the facts, as shown in the figure below.

Oil prices to end 2015

There is an oscillation. But it is modest and not driven by the assumptions of my model. Those had been premised upon two key factors. One was that OPEC would cease to be deterministic on price and that normal supply and demand conditions would be in play. That has happened. My other view was that when prices dropped sufficiently, demand would pick up, and in turn drive more shale drilling. Months after that kicked in, the new production would dampen price and so on.

Two major macro events have conspired to vitiate the theory, at least for now. China is practically in a recession, at least as compared to their explosive growth of the previous decade. The consumption drop, both real and perceived, is limiting oil demand. India, while not in the same state per se, has simply not delivered on the growth promise of Prime Minister Modi. This is in part because his party does not control the upper house (sort of like the Senate in the US) and in part because his mandate is being severely tested by a huge loss by his party in the populous state of Bihar. Business friendly changes will be slow to come. On balance, the two countries expected to produce increased demand are not showing up.

The other factor has been the so-called Fracklog. This is the inventory of wells that have been drilled but not yet fractured. The impetus for this approach was in part that this differed about two thirds of the cost until prices improved. The other reason to do it this way is to perform like tasks, in this case drilling and casing of the wells, all together. This improves efficiency in the logistics of materials supply and the like. Offshore platforms routinely operate in this way and a variant is known as batch drilling wherein even the drilling portion is done in batches (a single well is not drilled from top to bottom and then the next).

In the case of shale oil the next step, the fracturing, simply has not occurred for a number of wells waiting for better prices. That count is believed to be around 5000 wells. It was a scant 1200 or so early in the year. Assuming initial production from each well in the vicinity of 500 barrels per day (bpd), the effect would be a potential 2.5 MM bpd if unleashed all at once. That is logistically impossible even though each well could begin producing within a week of equipment arriving. But even an additional couple of hundred thousand bpd would move the price needle down measurably. Possibly speculators are concerned that cash strapped owners will do just that at some point. This bearish thinking may be a factor in the price staying down.

Another curiosity as of today (December 14, 2015) is that WTI almost has price parity with Brent. This is unprecedented going back at least 4 years. The spread has been about 10% until recently. It all began when shale oil really took off in volume and export restrictions limited its market. The figure below shows the trends.



My hypothesis is that the speculators are assuming that the export restrictions will be lifted. There has been a lot of press on Congressional action being imminent. Mind you, the horse trading to achieve that legislation is of the type that often stalls near the finish line. Nevertheless that is the only argument that makes any sense of the spread disappearing.

At this point I feel that the saw tooth behavior is still likely but at lower numbers until true demand creation and some destruction of the fracklog. Some smaller oil companies will fail but the properties will be snapped up by the better heeled independents; the majors will not participate much in this. They in turn will eschew the ultra-high cost developments such as the Arctic, which is all to the good. Their forays to date have been unproductive and in my opinion the environmental risk is not worth the reward.

Vikram Rao




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