Current Oil Price Decline May Set Stage For Price Spike And Global Recession

oil supply+demandMy Comments: There are relatively high taxes on the sale of gasoline at the pump where I live. In spite of this, we are almost at the $2.00 per gallon level. As I’ve mentioned before, this is both a good thing and a potentially bad thing.

The bad is that money invested to bring us domestically produced fuel and money invested to develop fuel efficient cars and trucks will be diverted and will appear somewhere else. Long term that is not a good thing for us. The world is evolving, as it has forever, and anomalies like what we are now seeing will have consequences.

Zoltan Ban / Dec. 30, 2014

• Current oil price decline is likely to lead to significant investment cutback, which will affect supply for many years to come.
• When the price of oil starts to recover, it will very probably spike, as there will be no supply mechanism able to react fast enough.
• A price spike will only be broken by a recession. It could be the beginning of a period of repeating such cycles.

For a few months now, there has been a very spirited debate in regards to the net effect lower oil prices will have on the economy. There are some who point to lower prices potentially bankrupting a large number of oil & gas companies, especially those that are mainly reliant on high-cost unconventional resources, such as shale oil, therefore it is bad for the economy. Others point to consumer demand being stimulated by the lower price of oil, which effectively acts as a tax cut for most households.

My take on the entire argument is that it is not as relevant as the fierce debate surrounding it might suggest. The effect on the economy might be a slight positive and the longer the lower price lasts, the stronger the effect. But there is no denying the fact that there are many oil extraction projects around the world that are not profitable at current price levels, therefore it is only a matter of time before the current price decline will lead to a drop in global production. Furthermore, even countries where the oil industry is mainly dominated by state-owned enterprises and production costs may be lower than the current price level, there will be a significant cutback in capital spending, because many of these governments are very dependent on oil revenues for their budgets. It makes perfect sense for a country like Russia for instance to cut investments in new projects until prices recover, in order to free up revenue for other government needs.

The effect of some investment cuts will be more immediate as may be the case with oil sands and shale oil. In the case of other expensive projects such as deep-water, the effects may only be felt many years from now. We have no way of knowing yet how deep the cut in production potential will be over the next few years, in part because we don’t know yet how much capital will be cut next year. Goldman Sachs projects that there may be a need for as much as a 30% cut in non-government owned projects around the world in order for the industry to avoid collectively taking a loss. ConocoPhillips (NYSE:COP) announced it will cut spending by 20% next year and it should not come as a huge surprise if it will cut even more as the year progresses (link). Many companies involved in shale drilling already announced they will cut their drilling activities next year. The announcements of plans for lower oil & gas investment are now coming in at a fast pace.

We have to realize that it will in fact not take much of a cut in the rate of growth in global oil production in order to close the relatively small glut in oil supply. The gap between supply and demand will be only about 400,000 b/d in 2014. It would have increased to about a million barrels per day by next year, if the supply/demand forecasts for 2015 would have turned out to be more or less accurate.

Thing is however that many projects take years from beginning till completion, so the effect may be felt only a few years from now. There will also be a slowdown in global production growth, especially in North America, where much of the global increase in production comes from since 2008, which will have a more immediate effect. Oil sands and shale oil projects do not have such a long lead time. If there is to be a reduction in supply in order to bring the market back into balance, it will most likely start with a decline in North American production growth, or even a decline in production.

As we can see from the chart, the US and Canada provided all the growth in oil production that the world needed since 2008. If the current low oil price will persist, it is probable that the shale oil industry in particular may suffer significant and probably permanent damage. The industry is vulnerable in large part because to date there has been very little self-sustaining growth in the industry. In other words, revenue re-investment is not sufficient by itself to push production volumes up. The main ingredient in the shale revolution has been the availability of credit. One of the main outcomes of the shale revolution has been the accumulation of about $170 billion in junk debt by many companies which are rated below investment grade (link). If the market will cut the industry off from continuing to accumulate debt, production will eventually stagnate and possibly decline as companies will have no choice but to cut back on drilling.

The production decline should help to stabilize the price of oil and eventually work towards the old plateau established starting from 2010, as long as there will be no global economic slowdown. The main problem I see is that when the price of oil will start to move back up, in response to a tighter supply/demand situation, there will be no mechanism in place to prevent the price of oil from overshooting. In other words, it will not stop at the tolerable $100 level we learned to live within the past few years, but continue climbing until demand destruction will occur. That means we are most likely looking at a global economic slowdown.

The reason I believe that the price will overshoot, is because just as there has been very little to keep the price of oil from falling in 2014 as for the first time in years there is a significant level of over-supply, there will also be little to keep the price from spiking as prices will rise too fast for new supply to catch up. The cuts in investment we are seeing right now will affect supplies for the next five years and even beyond. The extra spending companies will engage in once prices recover may in fact provide extra supply only once it will be too late. The recession inducing price spike could happen within a period of just a few months once the upward trend is established, while new supply may take many years to come online in response to the higher prices. In fact, the new supplies may come online only once the price of oil crashes again as a new recession takes a bite out of demand.

Future nostalgia for $100 oil plateau.
At an average price of about $100/barrel in the 2010-14 period, it was not a pleasant situation by any means. That price range was much higher than historical trends and it took out a bite out of potential global economic growth, given an economy that was built around much cheaper oil in past decades. Now that the price of oil is at a level that is more in sync with the economic needs, most of us feel much better about things overall. Pimco recently upped its estimate for global economic growth, citing lower oil prices, which will stimulate more consumption of all goods.

Needless to say that even though the economy feels better with the current oil price levels, many of the oil companies involved in producing the oil are not feeling all that great right now. That is especially the case with shale oil producers. What is worse, their financiers are not feeling all that great about them either and probably will be more cautious of them even when the price of oil will increase. As I pointed out in a previous article, there can be no shale oil production growth without the backing of lenders, because the industry cannot sustain itself from production revenue, which was the case even when the price of oil was in the $100 range (link). This is a very important fact to keep in mind, because resources such as shale oil and Canadian oil sands are the resources which could be the fastest responders to the price signal sent once oil prices start rising again.

With the response to the price increase much delayed and insufficient, there will be nothing else to stop the price from rising, except demand destruction and as we well know, demand destruction of oil means a recession, because oil is a very inelastic product. A recession will in turn cause prices to go back down again, which means that oil producers will have no choice but to cut back on investment once again, just as they are increasingly doing now. It is possible that we will be caught up in a long period of repeated cycles of oil price spikes and plunges, with the price failing to stabilize as it did after the 2009 price drop. The resulting effect on the global economy can potentially be devastating.

There is only one potential factor which could help prevent such a situation and that is OPEC action. All indications are however that OPEC is no longer in the business of oil price stability. I will not speculate on the possible reasons why Saudi Arabia seems to be unwilling to stabilize the global oil market, because there has already been plenty of speculation in that regard already. We can only go on what we actually know right now, and what we do know is that OPEC is currently dysfunctional. As I pointed out many times in the past year and a half or so, the current WTI price range that is sustainable more or less from both the consumer and producer perspective seems to be $80-120, with the price ideally spending most of the time in the middle of that range. We are now obviously very far outside that range, and when prices will recover, there is a very good chance that the price will overshoot the ideal range. If we will be unable to once again stabilize within the range I suggested, we will be looking at a period of great economic upheaval for many years.