Dec
15
Predicting the Oil Price Bottom
December 15, 2008 | 1 Comment
About 40 years measures the current period of the oil market being repeated shifting from a buyers market to a sellers market and back. We’ve been swinging back and forth with increasing extremes at both low and high prices and the peaks and valleys have started to be more frequent. At high prices the fundamental importance of energy and fuels can trigger worldwide economic slowdowns and the quick drop in price to the low extreme can trigger serious problems for the economies of some petroleum producers.
This volatility hasn’t been worked into production and buying patterns on either side. While Saudi Arabia tries to express the value of moderating expectations and pricing the world seems deaf. The U.S. with a good store of oil in its strategic petroleum reserve isn’t ready to use it to moderate the extremes, as the purpose isn’t to manage the market.
The Saudi effort misses a prime point, it’s that Saudi Arabia or OPEC itself needs a strategic reserve to blunt extreme high prices with the following precipitous low prices. I don’t mean oil in the ground as reserves or increasing pumping capacity, rather tanks that can be drawn in minutes or hours. Without that, all the talking has no muscle.
Buyers worldwide react slowly to prices with the poorest being first to respond and the related economic functions following soon thereafter. As we are seeing now, while excessive credit has had a big role in undermining the economy, energy and fuel costs saturate an economy quickly on the price rise and almost as quick on the way down. But the draw on cash has serious effects. Just as the middle class and the low-income groups suffer, governments and businesses have to absorb these prices too, reducing expenditures over time.
That makes having a sense of just how low oil prices can go an important consideration. But even more important is the sense of how long it will last. This blog isn’t about prophesizing; rather the goal is to understand. The results in the future are at risk for correction by the actual events over time. This makes the topics just two, the production we can expect at given prices and the consumption we can expect at given prices. Today we’ll look at the production at price. Divining consumption is a very different thing.
Every oil field or oil source has a price at which production can sell for a profit. For free world independent producers, when prices fall below the point of profit they simply “shut in” and wait as losing money on a risk earned asset would be the height of being foolish. But not all producers measure on profit, many and most of the world’s resources are under the control of governments with measures not at all considering profits and losses. But still, even they cannot go on forever, the lower cost producer will be a better seller for all other reasons that distinguish between suppliers. The high marginal cost producer will suffer more, sooner and longer than a lower cost producer. This reality is what tends to pull OPEC apart, entice quota cheating, and fuel their disparate goals.
For much of the world’s oil production the cost to sell a barrel of oil is meaningless, the social support for the economy and its population is the metric that matters. Without economies that produce wealth in goods and services these countries are at risk for civil unrest. The great adjustments that buyers suffer in high price rises are just as bad if not more grievous to the populations who are dependent on oil sales for life support.
What happens in the market is that oil supplies exceed demand by ever-larger amounts until the price gets so low that producers cannot stay in the game and drop out. At that time the exceeded demand shrinks continuing until the supply/demand margin gets closer and the inventory begins to shrink. Then the price will stabilize and reverse to an increasing trend.
The oil market is at the point way below the pain level for some social support priced oil, which only serves to make them antagonistic sellers. For oil sands such as in Canada, secondary production projects where the production costs close in on $40 per barrel preparations are being examined to “shut in” and tertiary projects are doing the same. It takes a while for these things to impact the market, but they could be coming, and will come just faster if oil prices fall further.
The timing is the main concern. If one were to buy future gasoline supplies it’s hard to imagine things could look better. Last week saw wholesale gasoline under $1.00 briefly. The difference between a gallon of gasoline in a budget from $1.40 to say $1.10 is not dramatic at all compared to that of $1.40 and $4.10. There’s that glinting squint moment. The price is now so low that for many contracting for all one can get is looking like a good idea.
But the futures market knows these facts too, you can’t get today’s price for this month next year. The businesses and people in that market know what you know now, the price of oil is near its practical lower limit. More reduced demand will not just widen the difference between supply and demand – it will shut in and delay investment in production. That in turn closes up the difference between supply and demand.
How long will it last? When will oil take off again? Demand reductions are still coming, so meaning months to turn back up. “Shut ins” are imminent, which is weeks to market impact or even days. Then there is the OPEC move to reduce supply, which may or may not be credible or have a noticeable impact on the difference between demand and supply.
Its possible that the market could see prices well below $40 for oil. But just as $147 killed demand going under $40 will kill supply. It’s already happening in a dance with demand destruction. But demand has a floor of sorts, beyond which the overall reduction in economic activity is intolerable across the entire trading world. Just what that daily oil use is makes for a question of intense interest. It’s even more important than the price that triggers the world economy to stop growth and reverse.
Here is this writer’s basic guide, $40 is the bottom for medium term oil prices and production costs for alternatives. The term of time we’ll be here is a function of suppliers ability to cut supply closer to demand so inviting a price run up when demand recovers. That hinges on the world economy getting back to growth. It won’t be days or weeks. It will probably be months if not a year or two.
But people are a vigorous species, static or depressed economies are creatures of oppressive governing and way too much of the world is economically free to create, innovate, and choose for themselves to stay down for long.
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