Why I think oil prices will not revert to the mean

When there is a major change in the supply of a commodity history doesn’t repeat.

There are a lot of advisers claiming that oil prices will revert to the mean. No one that I have heard is claiming that the price will stay low for a long time. However I disagree. The new technology of hydraulic fracturing of shale has greatly increased the US oil and gas supply over the last few years to the point that now, the US is almost independent of foreign oil. What is starting to happen all over the world is that the success of hydraulic fracturing in the US is now starting to be used world wide and discovering of new supplies of oil in shale all over the world. As these new discoveries start to mature, the supply will only continue to increase much faster than the demand will increase.

Although the current high cost of drilling and fracturing the shale in the US is not profitable at these low oil prices and will cause US drillers to back off, that is not true in many countries around the world that have much lower labor costs. Many countries that have low labor costs and buy much of their oil from oversees are now drilling and fracturing their oil shale as fast as they can with no sign of, or need to slow down. They see an opportunity to also become free of importing oil, and that is much more important that how much profit they make on their oil.

There is another reason that the price will not revert to the mean. Many of the countries that currently export oil use the income from oil to finance many internal projects that are ongoing and planned for the future. It is difficult for them to reduce their export volume without cutting back on these projects, which would increasing their unemployment, and cause an internal recession. Due to the current low prices they have internal pressure to sell MORE oil to keep up the income.

Denny,

"No one that I have heard is claiming that the price will stay low for a long time. " I have read several articles from energy analysts suggesting that oil prices could be depressed for a while due to increased efficiency in energy production (fraking) as well as decreased use of oil (less driving due to more people living in cities as well as more fuel efficient cars, expansion of clean energy programs, sluggish global growth, …). These analysts support your assertion. However none of them predicted the large drop in the price of oil so their predictive skills as well as those analysts that are predicting the price of oil to rise are questionable.

Scott

I agree with Denny that fracking technology will act as a governor on oil prices. Now that the technology has been proven in production, it can just be ramped up whenever needed. I think the other driver was Chinese consumption from building ghost towns. Heavy equipment in construction uses a lot of diesel and the Chinese are starting to decrease construction. Oil, though, has enormous energy density. It will always be in demand. I just read that electric vehicle sales are already getting soft.

It is difficult for most participants to recognize a new status quo but this was seen coming years ago and was not new to informed participants that simply looked at available public information (I myself owned SLCA some time ago and saw it go from 6 dollars to over 70 and now back to 25). This technology will effectively create a long-term “price ceiling” as supply will always come in at higher levels. Also, it is important to note that some projects required a lot of financing and must now pay interest that they most obtain by selling at least part of their production even if only marginally profitable. Both of these will create a ceiling not to mention both Venezuela and Russia (governments) get a lot of their income from oil production and must now sell more to make up for the reduction in their revenues so as to cover government costs. This is part of why Saudi Arabia did not cut production as they knew other OPEC members would not follow suit.

According to US government figures, worldwide oil production in September 2014 was up 6% over September 2010 with most of that increase in production coming from North America. (North American production increased 33%). Is 6% enough to cut prices in half, or was there a drop in consumption as well? Unlike oil production, the US government only lists oil consumption for OECD countries which are the big democratic countries. Oil consumption in the OECD countries was flat for the period. We can only speculate about Chinese oil consumption.

There are many ways society could be different. This dependence society has on oil is merely the path of least resistance and is not the most logical one. The development of fracking shows how vulnerable the oil model of energy is once the economics changes. Fracking itself could be replaced by yet another advancement if there was a will or necessity.

When SERIOUS money and effort is put to developing an ultracapacitor or battery that can preserve the power generation of solar, energy independence will be at hand and society’s current dependence on oil will seem positively antideluvian. The main economic constraint would be eliminated. It would be an advance that would surpass the internet in impact and maybe on par with the industrial revolution. Why is society not pushing much harder for such a giant breakthrough? Well it’s not in the interests of the current incumbents so the current main players aren’t funding it.

The Saudis know their oil has a sell by date after which it will be worthless made obsolete by technology so they don’t mind driving current prices to the ground to maintain market share even though their supply will be exhausted within a century. If they thought their product had longevity they would be much more hesitant in using this strategy. They need to keep Americans addicted to oil.

I have no idea what oil prices will do, but I believe a bet on long oil is a bet on rising volatility in the Middle East. If there is a huge spike in vol (another war or nuclear weapon or whatever), this long option could pay off very well.

More random thoughts:

Re: Oil

History of Oil prices:
r.search.yahoo.com/_ylt=AwrTccutnLVUa2gAt9QPxQt.;_ylu=X3oDMTByc25qcnVyBHNlYwNzcgRwb3MDNARjb2xvA2dxMQR2dGlkAw--/RV=2/RE=1421217070/RO=10/RU=http%3A%2F%2Fwww.wtrg.com%2Fprices.htm/RK=0/RS=X8uZIcBbwS3Z7Lm2w.IznkmujFg-

(This shows that oil could be expensive still now).
But contrast that with Charlie Munger’s quote:

[i]Oil is absolutely certain to become incredibly short in supply and very high priced … The imported oil is not your enemy, it’s your friend. Every barrel that you use up that comes from somebody else is a barrel of

your precious oil which you’re going to need to feed your people and maintain your civilization. And what responsible people do with a Confucian ethos is suffer now to benefit themselves and their families and their countrymen later. The way to do that is to go very slow in producing domestic oil and not mind at all if we pay prices that look ruinous for foreign oil. It’s going to get way worse later …

The oil in the ground that you’re not producing is a national treasure … It’s not at all clear that there’s any substitute [for hydrocarbons]. When the hydrocarbons are gone, I don’t think the chemists are going to be able to just mix up a vat and create more hydrocarbons. It’s conceivable that they could, I suppose, but it’s not the way to bet. We should spend no attention to these silly economists and these silly politicians that tell us to become energy independent.

Let me pose a question for you. It’s 1930. Oil in the United States is in glut. We have cartels to get the price up to $0.50 a barrel. Everywhere we drill we find more oil in our own country; everywhere we drill in Arabia we find even more.

What would the correct policy of the United States have been in that time? Well, the correct policy would have been to issue $150 billion of very long-term bonds and cart 150 billion barrels of Middle Eastern oil into the United States and throw it into our salt caverns and leave it there untouched until the current age.

It’s easy to see that in retrospect, but who do you see who ever points this out? Zero. We have a brain-block on this issue. We should behave now to do on purpose what we did on accident then.[/i]

So, if we have a 10 year horizon, $60 oil may very well be super cheap.

And, here’s what a dollar in 1930 is worth today - $12.35:
http://www.dollartimes.com/inflation/inflation.php?amount=1&year=1930

So, $0.5 in 1930 had the same buying power as $6.77 in 2014.

Annual inflation over this period was 3.15%.
Oil has gone from $0.5 / barrel to $45 at today’s prices. So, it’s significantly outpaced inflation, about 7X inflation. So, the price of oil has risen about 21%/yr over that eighty year plus period.
Now, Oil is still at $45.

The US is currently producing 3 million barrels a day. The world is consuming 93 million barrels / day. The US oil production, with fracking, is still a ‘drop in the bucket.’
The US Energy Information Administration, is projecting oil to be at $67 by year end with a much longer right tail for possible high prices, then a left tail for lower prices. That would be a roughly 50% increase in spot oil prices by year end.

http://www.eia.gov/forecasts/steo/report/global_oil.cfm
World production and consumption are moving in lock-step - there is no huge variance in these time series:

Inline image 1
So, I can’t really say if oil’s going up or down, but there’s some thoughts.

[quote]
"…none of [the analysts] predicted the large drop in the price of oil so their predictive skills as well as those analysts that are predicting the price of oil to rise are questionable.

Scott
[/quote]To quote Warren Buffett: “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”

What is the “mean”, and over what time frame? While $100 oil may be a stretch, current crude prices appear to be unsustainably low, because everything is elastic in the long run, including supply. While producers can hang on for longer than one might think, at some point it is uneconomical to continue, therefore reducing supply and increasing prices. The key uncertainty is the marginal cost of oil, which is now being set by shale due to the shorter capital cycle versus conventional projects. Drilling costs will most likely decrease as U.S. E&P capex has already decreased significantly in just a few months.

Regarding international shale production, my understanding is that unconventional plays are not producing any meaningful volumes overseas compared to the U.S. There have been many hurdles including the lack of widespread private land ownership, regulatory frameworks and expertise to name a few.

The main issue is the current supply / demand inbalance. But to put that into perspective, global demand is about 92 MBD, versus supply of about 94 MBD. If you take out the recent gains in U.S. supply, global supply and demand comes back into balance. The U.S. is producing close to 9 MBD, which is not insignificant compared to world demand.

All indications that I have seen point to a “U”-shaped recovery.

An interesting analysis, but the problem with this is that it is always possible to make a contrary argument, such as the one by T. Boone Pickens:

Full article here: http://www.cnbc.com/id/102364314?__source=yahoo|finance|headline|headline|story&par=yahoo&doc=102364314

Time will tell but the market is always right. I think it is a more efficient use of my time to watch what the market is doing, and work on strategies to respond, rather than trying to predict what the market will do. But then I am no T. Boone Pickens, or Denny.

The main issue with the bullish argument for oil is that it doesn’t explain the Saudi increase in oil production. What makes the oil bulls think the Saudi action is temporary or unsustainable? The Saudis increased their production for a reason (why is still unclear from my perspective) and until that reason whatever it might be goes away the bull argument focusing on reduction in North American fracking is incomplete.

The latest information that I’ve seen shows that Saudi production is flat. Where did you see that production increased? They certainly have the capacity to increase if they wanted to.

If I were to speculate, I would guess that the Saudis are happy that one of the major funding sources for ISIS - oil - is drying up. It may cost them 100’s of billions over time, but the USA spent 2 trillion on Iraq.

EDIT: Low oil prices also puts pressure on the other Saudi antagonist - Iran. And it helps an ally - the USA. I think that the Saudis are more politically motivated at this point and not so much market share concerned as the popular press is reporting.

As I read these interesting post I wonder two things:

  1. Could Saudi Arabia hold together the cartel if it wanted to or would the members produce more than their quotas to the point that the cartel would fall apart. If I understand Denny correctly, he thinks the members are under too much pressure and would not stick to their quotas. He also, I think, makes the argument that there is increasing competition that reduces the monopoly (ok oligopoly) power of the cartel.

  2. Does anyone have any idea how much Saudi Arabia would produce in a truly free market? Would it produce even more? Or is it producing more than it would in a free market to destroy competition? What is the “natural” price of oil in an imaginary world where producers could not collude? I think it must be less than the present price or Venezuela, Russia, Brazil and Iran would have stopped producing.

As I write this, I think I might have answered my own question: the natural free market price is below the present price and the future price will depend on Saudi Arabia’s ability to limit supplies in the future. Now that I think about it: like Denny said. I hope he is right about the weakening of the cartel’s oligopoly power.

All:

FWIW:  I think the Saudi's know a lot about the oil market.  I also think they believe their actions are in their interest.  So what exactly is their aim?

My speculation:  They want to remain in a position to at least partially set price, so as the lowest cost producer ( <$10/bl) they are taking a page from Carnegie's playbook. Specifically, they want to: 1) Prevent rigs from drilling off the coast of Brazil.  [Reserve Est 10-20MM bl/day .  This oil costs net about $70/bl to extract, but once a well is dug it only costs about $10-15 to produce.] 2) They want to take some of the recent capacity additions, particularly from fracking and tar sands off the market. 3) They want to give some of the other members of OPEC a good spanking in order to instill future discipline.

I'm not sure how successful they will be.  For sure they can keep Brazillian oil off the market.  They can also cause a lot of dislocations in the U.S. oil and gas industry, and give the other members  of OPEC a spanking.  BUT...our [and a good deal of the rest of the world's] oil would still remain in the ground and should price head north of $40 for a substantial amount of time it's hard not to believe that, incrementally, frackers would gain confidence and resume operations.

OT:  Now would be a great time to implement a fairly steep carbon tax. It would help our environment, spur alternate energy R&D, and we could use the proceeds to fix our infrastructure and pay a piece of the national debt.  I would start with the grid.  This is priority from all of the following perspectives: infrastructure, national security, and climate change.  Just a thought.

Bill

I was basing my comments on their action in September 2014 as I gleaned from this article:
http://www.businessweek.com/articles/2014-10-23/oil-saudi-arabias-risky-price-play

Not very recent or large as these things go but it was well into the slide.

My background in this and why I started this thread: In 2004 after studying most of what I could find about shale well horizontal drilling and hydraulic fracking I contracted with an oil and gas development company to drill 10 wells on our 340 acre ranch in the middle of the Barnett shale. Since I am an engineer I was very intrigued by the fracking technology and have studied it and the industry for over 12 years now. I have kept up with many of the larger company’s actions and plans. I have direct information from companies in Texas that are moving from Texas to other countries dozens of their drilling rigs, their fracking rigs, and their drilling and fracking teams.

Many of the drillers are highly leveraged and with the lower price of oil, the drilling is not very profitable in the US. However, there are a number of foreign countries that are desperate to reduce their dependence on imported oil. They are paying high premiums to bring in teams and equipment. By relocating their teams and equipment the drillers that have marginal profits in the US can continue to cover their loans, keep their best teams employed, and still make a profit. As long as there is a demand and they can make a profit their moto is “Drill, baby drill”.

As of the end of 2014 the estimate is that less than 2% of the recoverable shale gas & oil has been recovered in the US. A shale well is estimated to have a 40 to 50 year economic life with existing technology. In the Barnett shale in Texas, which started the horizontal drilling and fracking technology over 15 years ago, some of the wells that are over 10 years old had declined to 20 or 30% of their initial production. However, a number of them have been experimentally re-fracked with their production doubling from their declined levels. That implies that the life of a well may be even longer than initially estimated.

The US is currently the only country that is producing shale oil and gas in a significant commercial volume. There are 137 shale formation that have had exploratory drilling in 41 countries outside of the US, and they have an estimated 345 Billion barrels of oil and 7300 Trillion Cubic feet of gas. That is 10 times the amount estimated in the US. That data doesn’t include the many known shale formations that haven’t yet had experimental wells or the many countries in which there is no information about shale formations.

As long as there is ANY profit in drilling these shale formations, they WILL be drilled. With that background, does anyone still think the price of oil will go back to $100 within the next decade? Here is a summary of shale gas & oil formations worldwide with a map of the known areas (the data is a year and half old):

http://www.eia.gov/todayinenergy/detail.cfm?id=14431

Drill, Baby Drill!

Denny,

there are countries in which fracking will probably not take place in the next 10-15 years because of concerns about the environmental impact.
Germany is one of them (I do not think this will have a big influence on the oil and gas prices).

The correct prices of energy include the likely environmental impact of production and consumption for the next thousands of years (including greenhouse effect). But these prices will be probably not recognized as soon.

Do not drill, Baby!

Matthias

Sorry to be opinionated here, I just could not hold it back!
First of all, I follow Dennys Argument, I think the same way.
I am a huge fan of solar, wind and other alternative energy’s but I think, there needs to be a very high productivity boost in them, otherwise there growth will go much lower. Same with battery driven cars like teslas. I got a solar roof that is heavily subsidized by the german governance (get 25c per unit, Market Price is 14c!), I lower my utility bill with this from 300 to 150 euro for a 320 Square Meter House.
I had an conversation with an industry specialist and a geologist and hey just laughed at “Peak Oil”. Geological Oil and Gas Production is a constant process (like growing Woods) and new estimates Show that only 8% of all reserves worldwide have been drilled and mined (they add sand oil to the equation), even the left-liberal wing Spiegel German magazine, that I read since 1984 every week, just confirmed this and they confirmed that fracking (done well) makes no harm to the environment (and fracking is possible in Germany, only every project needs to be allowed by the local government).
And I have to admit, I also hope Denny is right, since I changed my mind on the whole subject, since cheap energy is going to boost hopefully this decades economy big time. I hope that if prices stay low, it will give us a long lasting bull market.
And the wind and solar lovers (I am one of them and I hope they get much more efficient) got to be fair to the Drillers, they adapted adorable monster big time (and I thank them for that!) and kick ass now and I believe the theory that they will in the future and a lot of them could not care less about oil at 40 (okay that is bit exaggerated, LOL!).
If global warming is made by humans (what is probable), well then it can not be hindered. People are not going to do the (may be short term) economical wrong thing just to hinder global warming, no political process will this make happen nowhere in the world, I think Germany is no exception here with a huge bet on alternative energy (but so far we produce even much more carbo, since the coal based production is up very much). We will probably have to adapt to global warming and we will find solutions here too.
So I just ordered a BMW 335i with 306 horsepower (still energy efficient, but they got much more energy efficient cars) and will have some fun now!
Congrats to the Drillers!
Drill, Drill Baby Drill!!!

Is the recent steep drop in oil prices solely due to supply and demand? While relatively flat, or even reduced, world consumption and slight increase in world production supports this thesis, food for thought is there very well may be political implications just as equally responsible. The Saudi (and other Mid East producers), Europe and America political interest may all be a little different, but aligned to drive oil prices lower. In part, I would not fail to consider that there are political pressures to drive the price down to punish Russia for its recent aggressions.

If we only had to analyze supply and demand in the near term for investing our job would be a cakewalk.