Oil Warning: The Crash Could be Worst in more than 45 years – Bloomberg News
According to the article confidence in oil prices was based on four premises and if these four scenarios occur then oil prices will surge.
1. Demand will rise: check
a. The crash in prices should prompt a rise in demand – despite the slowdown in China, global demand has increased to 1.6 million barrels a day relative to last year’s report
2. Spending on new oil will fall: check
a. Lower prices means lower spending on new oil supplies and cost of drilling and pumping should decline – since October the # of rigs actively drilling for new oil around the world as declined by 42% and in 2015 oil companies have cut about $129 billion in capital expenditures
3. Stock prices remain low: check
a. While rebalancing of oil market is taking place, stock prices of oil companies should remain cheap, setting a stage for a strong rebound – oil majors are trading near 35 year lows, using two different methods of valuation
4. Oil supply will drop: Uh-oh
a. With strong demand for oil and less money for drilling and exploration, the global oil glut should diminish – the opposite has happened, OPEC production surges in 2015 amidst low oil prices.
Implication/Comments: #4 explained - 2 reasons.
I think what the article failed to mention is that there are two fundamental reasons why oil supply did not drop.
1. Each country that is in OPEC or that relies heavily on oil for its governmental spending created budgets to accommodate the surge in oil prices. The surplus created from $100.00 per barrel increased the budget of each respective country. As a result, with the contraction of oil prices, these countries budget have a deficit in their budgets. In this case, twice the deficit $100.00 à$50.00
a. Pumping oil from existing oil rigs cost these countries little overhead and it is relatively ‘cheap.’ With prices down to half of what it was last year increasing their production to twice as much as the year before is logical to meet deficits created by lower oil prices.
2. If a country was to lower its production then other suppliers will take over their market, this might eventually increase oil prices due to lower supply, but which country would lower its production and lose its revenue stream? Also, knowing that if they did it, it will be taken over by another supplier and benefit that other country in the processes and might even lose their current clients – which country would take the hit?
a. USA drillers are also in the same tight spot. Most of the shale drillers and other energy suppliers that were created between 2007 – 2014 borrowed their money to begin their rig/operation. They created their budget forecast to pay off lenders with a $100.00 per barrel price at a certain production level with maybe a few dollars to accommodate for risk. But it was never predicted to go decrease to as low as $50.00 per barrel, therefore budget forecasts created to pay off loans, operations and profits based on a certain production level is completely wrong and the only way to correct their forecast is to either renegotiate their loan obligation and tighten up their cost of operation or increase output to twice the amount in order to hit objectives.
Those are the reasons why supply is high right now and it is not likely to go down, even considering a low oil price.
