Dropping Oil Prices: What Could Go Wrong?

First of all, don’t listen to the doomers. It is not the end of the world.

Here are a few things that are likely to happen in the short term in North American oil plays:

As oil prices drop, producers will undoubtedly renegotiate their ludicrously expensive oil service contracts, slash wages for their workforce and cut perks to bring their costs in line with the depressed price for crude. The demand for oil remains strong, which should provide an adequate floor for producers in the long run, but only after they get their finances in order. _Fortune

In market economies, prices are expected to rise and fall, so mechanisms are in place to deal with such fluctuations. Some drilling projects will be postponed, and some will be cancelled for the time being. Oil companies will cut costs wherever possible, to maintain profits — and many new technologies are helping in that regard.

But if prices continued to fall, some companies would go out of business. In many oil-producing countries, governments would default on debts and some governments would fall and be replaced.

How Low Can Oil Prices Go?

First, global supply is still high, and global demand is still low. So prices are not likely to move strongly upward terribly soon. A lot depends upon the strength of the US dollar — which US President Obama seems determined to destroy, in the long run — and on the strength of the economies of Europe and the Anglosphere. Those two economic blocs have been the power drivers of the global economy.

What’s going on is that the world is awash in crude oil while the world economy is slowing down. Demand for crude has dropped, yet supplies are increasing; the predictable result is lower prices…

… demand for oil appears to have peaked in the United States and Europe. This is due in large part to the recent period of sustained high prices that encouraged drivers to buy more energy-efficient vehicles and to conserve the amount of fuel they burned. U.S. gasoline consumption peaked at 142 billion gallons in 2007 and has since fallen by 6 percent to 135 billion gallons in 2013. In the European Union, transport fuel consumption has fallen by 8.4 percent since peaking in 2007. _Reason

Oil prices could go lower without killing off the US shale boom. But not much lower than $50 bbl. Russia, Iran, Venezuela, and other oil states are in real trouble.

Will Low Oil Prices Hurt Investors and Banks

Of course, at least for some. In every bet, there is a winner and a loser. Many idiot investors and bankers bet that oil prices would rise monotonically. They will pay the price for their stupidity.

“While I’m certain over the long run the lower price is a net benefit to the world, the staggering speed with which it has fallen is destroying debt and equity values throughout the energy sector,” writes Belpointe chief strategist David Nelson. “My crystal ball isn’t any clearer than yours but if there’s a Black Swan lurking you’ll probably spot it floating near some oil rig.”

While oil prices and related stocks get most of the attention, Nelson notes energy accounts for about 16% of the high yield bond market and that banks have lent $465 billion to oil and gas companies in 2014, according to Thomson Reuters LPC; that’s up 29% from the previous record set in 2007.

… “historically, sharp drops in oil prices tend to be associated with recessions as energy demand collapses,” The WSJ notes in the story cited above.
__ Finance.yahoo

More on investor downside in low oil prices

I think we can certainly expect recessions in Russia, Iran, and Venezuela if oil prices remain low.

Low Oil Prices Can’t Last Forever

Analysts polled by Reuters have forecast an average Brent price of $82.50 a barrel in 2015, down $11.20 from the previous survey and the biggest downgrade since the global financial crisis, with OPEC member Nigeria cutting its own projection to just $65 for next year.

… In a recent research note, Morgans chief economist Michael Knox suggests that the oil price “will only stay low while the U.S. dollar is rising.”

… According to Knox, the falling oil price has resulted in “one of the fastest rises in the US dollar since the early 1970s…Once the US dollar ends this major move, the oil price will go back to being driven by normal fundamentals of supply and demand. Our view is that the normal levels of supply and demand suggest a price of Brent oil of more than $100 per barrel.” __Diplomat

This is a fascinating dynamic picture: A fight between market forces of supply and demand, currency rates (particularly US dollar strength), global economic health and energy demand, and behind the scenes manipulation by big traders and oil producers. The outlines of the struggle are reasonably clear, although the exact timing of coming events cannot be confidently proclaimed.

Don’t Panic

Oil & gas producers will re-negotiate contracts with labour, service companies, and suppliers.

… as the oil price drops, so will costs, bringing the “break-even” price down with it. Seasoned oil men know how to get this done—it involves a little Texas theater, which is sort of like bargaining at a Turkish bazaar. The producers will first clutch their hearts and tell their suppliers that they simply cannot afford to drill any more given the sharp slump in oil prices. Their suppliers will offer a slight discount on their services but the producer will say he’s “walking away.” This is where we are in the negotiating cycle.

After letting the oil service firms sweat a bit (traditionally around two to four months), a producer will give their former suppliers a call, saying they are “thinking” of getting back in the game. Desperate for work, the suppliers will now be willing to renegotiate a whole new agreement based on a lower oil price. The aim of the new contract is to give producers close to the same margin they had when prices were much higher. Profits are restored and everyone is happy. __Fortune

In other words, US producers — for the most part — will be able to withstand even lower oil prices than currently exist. There is a limit, of course. But the supply and demand mechanisms of markets contain their own self-regulating mechanisms, which serve to prevent the utter devastation of industries — although individual players will come and go.

Hard-pressed oil producing countries operating well below fiscal breakeven, are dipping into sovereign wealth funds to meet payrolls and pensions, and that problem is likely to get worse before getting better. Many oil producers have not been particularly honest about their reserves funding, and a day of accounting for some of them may be at hand.

Watch the Underlying Fundamentals

The bottom line is that commodity prices can often turn quickly, particularly for those who do not understand the underlying fundamentals. Expert analysts disagree over whether $100 bbl oil is the proper level — or whether $100 bbl oil is overpriced. Much depends upon the strength of the US dollar. But many other factors are involved, and it would be stupid to ignore them when making investment plans.

Oil producers: up and down
Venezuela into the Abyss

More: A “doomer-esque” take on low oil prices from Gail Tverberg, who seems to be struggling to reconcile her long-standing belief in “peak oil cataclysm” with the many twists and turns of oil production in the real world.

Many collapsitarians over the years have been caught quite flat-footed by the refusal of the real world to adhere to endless doom scenarios. Doomers usually find ways to survive well, long past the many predicted dates of universal collapse. More links to stories of failed dooms

This entry was posted in Doom, Economics, Energy, Oil Prices and tagged . Bookmark the permalink.

6 Responses to Dropping Oil Prices: What Could Go Wrong?

  1. Matt Musson says:

    I grew up in the oil patch. This is when they cut back from working week on / week off to a regular 40 hour shift. With 7 12 hr shifts you work 84 hours in a week and get time and a half for 41-60 hours. After 60 hours you get double time. So, you make way more money and get every other week off.

    Of course everything is relative. I remember when oil dropped from $20 back to $8. A popular bumper sticker read :

  2. Abelard Lindsey says:

    Betting on endlessly increased oil prices has actually produced several spectacular business failures over the past 30 years.

    The bankruptcy of Penn Square bank of Oklahoma with their “participation” loans in 1984 is one memorable failure. Seattle First bank was caught in this and had to be bought out by Bank of America in 1985. Another is McDonnell Douglas and their MD-11 plane. The MD-11 was more fuel efficient than the 747-400 (both came out in 1989). McDonnell Douglas bet that rising fuel prices would cause the airlines to favor the MD-11 over the 747-400, among several other features of the MD-11. Fuel prices went down and many more airlines bought 747-400’s rather than MD-11’s and McDonnell Douglas sailed into history.

  3. bob sykes says:

    A number of commentators think the world as a whole is sliding into another recession, Europe especially. This may put more downward pressure on oil.

  4. Hell_Is_Lke_Newark says:

    I would also point out that producers regularly hedge their production. Many producers won’t feel any strain, for a some month at least, as their current production is likely locked in at a certain price point.

  5. etienne says:

    You could speculate a lot on what could happen. Because of the enormous amount on paper/futures and automatized computer trading it’s very likely that the oil price will go down to at least 31-32 $ or even lower for a short period of time because that’s where computerized trading programs based on technical analysis data will push it towards.

    That could trigger instability in many countries which will fuel a capital flight into the US$. The US$ will likely appreciate strongly which will be positive for US-Elites but bad for Americans and Corporations who are deeply in debt.

    An appreciating US$ could push the price for oil to even lower levels.

    Many conservative/libertarian analysts believe in strong inflation in the US but the opposite seems to be coming.

  6. yoananda says:

    But King Hubbert and Malthus DID have right.
    King Hubbert predicted pic oil USA, and it did happen.
    Malthus collapse did happen : it’s called WWI !!
    Collapse doesn’t mean end of the world, it means, “big troubel ahead, and maybe, if we let thing happen, the end of the world”.
    Throughout history there have been many collapses : somme short and hard, some long and soft, some short and soft, and so on.

    Now, the “oil collapse” is inevitable, it’s too late. But who know what’s coming next ? graphene ? nuclear fusion ? cold fusion ? etc…

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