Article / 01 March 2016 at 18:15 GMT

Oil price recovery looks doomed to fail

Managing Partner / Spotlight Group
United Kingdom
  • Any deal between Saudi Arabia and Russia will prove fragile
  • Iran will not cut production; it would miss out on the benefit of the sanctions lifting
  • Shuttered onshore US rigs can be reopened, capping oil price upside

 One factor that caps upside potential for oil is that shuttered production can be reopened. Photo: iStock

By Stephen Pope

As the oil price has fallen since June 2014, it is no surprise that several of the largest shale oil producers have now sought to restrict their production. This is the first time they have done so in several years. The major shale producers have finally started to throw in the towel and so joined the smaller, less efficient or marginal producers.

They have finally acknowledged that the massive supply glut, if it remains unchecked, will keep prices at their current depressed levels.

Twelve months is an eternity in the oil market

The latest production cuts come as shale operators have shown nasty numbers in their latest quarterly accounts. This is a 180-degree turn from the situation a year ago when drilling companies kept the spigots open and let the oil flow even as oil prices kept plunging.

The Organization of the Petroleum Exporting Countries continues to pump at an aggressive rate in a determined effort to retain market share.  Saudi Arabia gets 74% of its export revenue from crude oil, and it has become irritated that US shale oil production had ramped up so much that it accounted for 10% of global supply. This placed US shale on an an equal footing in terms of volume with Saudi Arabia and Russia.

Shale Oil

Source: Reuters

The Saudi Arabian oil minister Ali al-Naimi and de facto leader of Opec has acted single-mindedly since mid-2014 to protect the Kingdom’s long-term oil survival. He has refused to limit Saudi oil production to prop up the price, and instead has chosen to use Saudi Arabia's predatory pricing power to force out higher-cost suppliers.

Last week in Houston, Texas he told American energy executives that the supply problem will only be resolved when low prices force companies to stop producing the oil that is most expensive to extract and sell. His message was loud and clear: “…Inefficient, uneconomic producers will have to get out, that is tough to say but that’s a fact. …”

After boosting oil flows for several years across states such as North Dakota, Oklahoma and Texas, leading US oil producers, including Continental Resources, Devon Energy and Marathon Oil, have suggested that they will reduce oil extraction by 10% in 2016 from 2015 levels. 

The Wall Street Journal noted that EOG Resources also announced on February 26 that was planning to reduce production and expected to pump 5% less oil this year.

This trend of reducing production has seen the Baker Hughes oil rig count decline for 10 straight weeks. During the last four weeks, the decline gained momentum to reach the fastest rate in about a year. Further rigs are expected to stop working by the end of the second quarter of this year.

Data from Norway's Rystad Energy indicates that fewer than 20% of wells drilled this month can break even at oil prices below $30/barrel. When accounting for other costs, such as transport and general and administrative expenses, this figure is meaningfully reduced.
Baker Hughes

Source: Baker Hughes , Business Insider

Financial services firm Cowen & Co. forecast an onshore US rig count bottom of 375-400, possibly occurring in April.

A hallmark of the shale oil industry in the US has been a rapid rise in efficiency that has allowed wells to be tapped for less capital cost. The industrty has also seen a steady improvement in the extraction process that has made more oil accessible than was originally forecast.

The news from US producers is clearly more than just a decision to reduce extraction activities. It implies that a strategic decision is being taken in the face of ongoing pressures such as Opec supply, new and legal oil about to flow from Iran. Combined with the current glut, it means that oil prices will stay lower for longer. That is going to create trouble for a number of shale producers and their creditors as, until now, many pumps have been kept operating to ensure that producers could service their loans or honour lease obligations.

At what price can shale oil be profitable?

When the price of crude oil first began its decline from approximately $107/barrel in June 2014 the shale industry showed a brave face as it claimed that shale oil companies would be profitable at a price of $60 /barrel. When that level was broken in December 2014 the price of $50/barrel was claimed to be acceptable.

Since then the price has fallen further and taken the shale industry into uncharted waters. As discussed above, the sudden collapse in the US rig count would imply that operations have largely become uneconomic when prices rotate between $25 and $35/b.

The geological structure of each well is different and so the variable costs of oil extraction are similarly prone to differ in each case. So there is no uniform or singular price at which shale oil is economically viable.

If one totes up all the variable costs of machine operation, labour, extraction, storage, local taxes and environmental charges, then just 1% of all potential shale oil well heads in the Bakken area of North Dakota, a typical shale area, can be classified as profitable — a shockingly low figure.

The path of breakeven oil prices for shale has declined steadily over the past five years or so, but this is far from a linear industry, so it would be foolish to believe that one can extrapolate the decline in breakeven prices for the industry on an ongoing basis.

We may have reached the end of the road, as there are indications that easily recoverable shale oil is drying up. So even if technology and labour efficiency improves, when matched up against less accessible reserves, the net effect is no change in the breakeven value.

Overall, the Energy Information Administration expects US production to fall by 700,000 barrels/day by the end of 2016 to 8.5 million barrels, or more than 1 million bpd below the 2015 peak.

If oil prices rise, can closed rigs be reopened?

For land exploration, extraction equipment represents one of the two major expenses for oil producers. The other is the cost of establishing infrastructure access for roads, water and electricity.

Once established, roads and other utility infrastructure is in place and available at a relatively small maintenance cost. So, if oil prices were to pick up in a sustainable way, it would not be too much of an expense to reactivate rigs.

In fact, as one moves from a minor, small footprint rig to a mid-sized structure, the cost per barrel of oil will decline as economies of scale come into effect. The price of oil rigs for land drilling in the US typically starts at around $18 million to $25 million. However, depending on the specifications of the actual rig deployed, it can be nearly twice that amount.

The oil price remains volatile and low, but it has also been undeniably heading upwards overall since twice hitting its recent base territory at $26.12/b on January 20 and $25.99/b on February 11. Cynics like myself are minded to ask if there are significant factors that will undermine the latest attempt at recovery.

Recent talks between Saudi Arabia and Russia, which led to a tentative deal to freeze production, have generated hope that the glut may be about to stabilise, even ease. Saudi Arabia on February 29 gave confidence boost to investors by stating that the Kingdom "will always remain in contact with all main producers in an attempt to limit volatility and it welcomes any cooperative action …"

But these are just words, and bureaucratic talk is just not going to cut it any more. Data from the New York Stock Exchange yesterday showed that bullish bets on oil prices rising in the future are now at their highest since records began in 2011. However, I cannot help but join those who point out the many reasons why this nascent rally may yet be undermined.

First, production deals are notoriously shaky, and the Russians have backtracked on apparent deals with the Saudis in the past. The Russians should not mistake Saudi Arabian deliberate short-sightedness for economic blindness.Then one must ask how any production deal will accommodate Iran? Getting the right answer to that question will prove extremely difficult.

Oil barrel in the desert
 How will any production deal accommodate Iran, which is 
hungry to ramp up exports. Photo: iStock

Oil is still flowing onto the market at a rate of two million barrels a day above demand. Shale production has fallen, but it is still higher than the Street had estimated. If prices do push toward $40/b, it is quite realistic to see shuttered facilities being reopened.

For the rally to push prices back above $50/b there will need to be an extremely deep cutback in Opec production. The Saudis and the Russians will have to exhibit a commitment to reduce production levels to remove excess supply in the face of Iranian oil and shale creeping back into economic viability.

I just do not see it happening, and for that reason I believe low-priced oil is as much a part of the new financial landscape as low interest and inflation rates.

— Edited by John Acher

Stephen Pope is managing partner at Spotlight Ideas

ozy ozy
Good article Stephen, thanks.. Which sid you trade now? I keep long positions, and expect $45 by june
Stephen Pope Stephen Pope

Thank you for your kind words re the article. I am minded to be a seller of oil as I see the tech picture showing only the five hour to one day measures suggesting a BUY. The very short measures or the the longer looking week and month say Strong Sell.

I have little faith in any of the Opec nations or any outside oil producer being willing or committed to restraining production in any meaningful way. Plus I come back to the problem of Iran.

Having been frozen out of the "legal" market ... as we all know they were finding a path for their oil through back channels I cannot see Tehran agreeing to holding back.

Besides if oil starts showing some potential to move toward and hold higher prices it will just hand an incentive to the shale operators to stage a return. So I expect a price rotation between 26 and 26.

Vitor Oliveira Vitor Oliveira
Very good! So, nowadays, there is only one time horizon, which is very short term positions, 1, 2, 3 days.
TroyEarth TroyEarth
Very nice piece indeed Stephen thanks a lot. Just curious, if its possible to get some referances on the mentioned figures? paricularly only 1% of shale producers are profitable in North Dakota... Thanks again for the great work..
ozy ozy
Stephen, I'm not so pessimistic on Iran case. I hardly belive opec-non opec cooperation will get a deal, also supported by iran. because Iran need high oil prices to get in foreign investment to be able to product enough as they aim to arrive pre-sanction levels, but without high oil prices noone want to invest for oil, not in iran, also everywhere on the world, while big producers companies looking for investment cuts...So, I think inside a deal of opec-non opec production freeze, they can find a solution for iran, not freeze for them but to limit production rise, may be to limit it 800k bpd rise till next year end.. Iran could be happy also in that case, because oil price will go up, they will take more investement country in..I think, also they know they can not arrive that production level as they mentioned 500k this year and 1m next year, in these conditions. just have a look their january production rise is only 38k... I wonder what they did in feb, we'll see it next opec report
TroyEarth TroyEarth
Thanks Stephen.
ozy ozy
Hi Stephen, what do you think about this? : in these days contango between next contracts is around $2.. it was usually around $1 or $1,5.. but warehouse prices for crude became more expensive because of inventory builts, and filling near maximum capacity of storage tanks...So, if you look dec16 contract CLZ6, it's $40.45 at the moment.. till that 8 times contango will cost on each months contracts... if you think each month $1,5 contango average 8X1,5=$12...normally dec16 contract have to be $34.50+$12=$46.. So they do $6 dollar discount to you if you rent that storage tank for your CLZ6 contract in advance....if crude price remain unchange till dec16 but only add contango every month it will be anyway $46 with that math... so, $6 profit while crude price unchanged....
Stephen Pope Stephen Pope
That is a strategy that is worth following Ozy.
TradingTom TradingTom
Beautiful analysis. I am staying put for a long time now and seeing everyone getting fried in oil.


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