How Low Can the Price of Oil Plunge?

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It is possible that a miracle intervenes and that the price of oil bounces off and zooms skyward. We’ve seen stocks perform these sorts of miracles on a routine basis, but when it comes to oil, miracles have become rare. As I’m writing this, US light sweet crude trades at $76.90 a barrel, down 26% from June, a price last seen in the summer of 2010.

But this price isn’t what drillers get paid at the wellhead. Grades of oil vary. In the Bakken, the shale-oil paradise in North Dakota, wellhead prices are significantly lower not only because the Bakken blend isn’t as valuable to refiners as the benchmark West Texas Intermediate, but also because take-away capacity by pipeline is limited. Crude-by-rail has become the dominant – but more costly – way to get the oil from the Northern Rockies to refineries on the Gulf Coast or the East Coast.

These additional transportation costs come out of the wellhead price. So for a particular well, a driller might get less than $60/bbl – and not the $76.90/bbl that WTI traded for at the New York Mercantile Exchange.

Fracking is expensive, capital intensive, and characterized by steep decline rates. Much of the production occurs over the first two years – and much of the cash flow. If prices are low during those two years, the well might never be profitable.

Meanwhile, North Sea Brent has dropped to $79.85 a barrel, last seen in September 2010.

So the US Energy Information Administration, in its monthly short-term energy outlook a week ago, chopped down its forecast of the average price in 2015: WTI from $94.58/bbl to $77.55/bbl and Brent from $101.67/bbl to $83.24/bbl.

Independent exploration and production companies have gotten mauled. For example, Goodrich Petroleum plunged 71% and Comstock Resources 58% from their 52-week highs in June while Rex Energy plunged 65% and Stone Energy 54% from their highs in April.

Integrated oil majors have fared better, so far. Exxon Mobil is down “only” 9% from its July high. On a broader scale, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) is down 28% from June – even as the S&P 500 set a new record.

So how low can oil drop, and how long can this go on?

The theory is being propagated that the price won’t drop much below the breakeven point in higher-cost areas, such as the tar sands in Canada or the Bakken in the US. At that price, rather than lose money, drillers would stop fracking and tar-sands operators would shut down their tar pits. And soon, supplies would tighten up, inventories would be drawn down, and prices would jump.

But that’s not what happened in natural gas. US drillers didn’t stop fracking when the price of natural gas plunged below the cost of production and kept plunging for years. In April 2012, it reached not a four-year low but a decade-low of about $1.90 per million Btu at the Henry hub. At the time, shorts were vociferously proclaiming that gas storage would be full by fall, that the remaining gas would have to be flared, and that the price would then drop to zero.

But drillers were still drilling, and production continues to rise to this day, though the low price also caused an uptick in consumption that coincided with a harsh winter, leaving storage levels below the five-year minimum for this time of the year.

The gas glut has disappeared. The price at the Henry hub has since more than doubled, but it remains below breakeven for many wells. And when natural gas was selling for $4/MMBtu at the Henry hub, it was selling for $2/MMBtu at the Appalachian hubs, where the wondrous production from the Marcellus shale comes to market. No one can make money at that price.

And they’re still drilling in the Marcellus.

Natural gas drillers had a cover: a well that also produced a lot of oil and natural gas liquids was profitable because they fetched a much higher price. But this too has been obviated by events: on top of the rout in oil, the inevitable glut in natural gas liquids has caused their prices to swoon too (chart).

Yet, they’re still drilling, and production is still rising. And they will continue to drill as long as they can get the moolah to do so. They might pick and choose where they drill, and they might back off a smidgen, but as long as they get the money, they’ll drill.

Money has been flowing into the oil and gas business like a tsunami unleashed by yield-desperate investors who, driven to near insanity by the Fed’s policies, do what the Fed has been telling them to do: close their eyes and hold their noses and disregard risk and hand over their money, and borrow money for nearly free and hand over that money too.

Oil and gas companies have issued record amounts of junk bonds. They’ve raised record amounts of money via a record number of IPOs. They’ve raised money by spinning off assets into publically traded MLPs. They’ve borrowed from banks that then packaged these loans into securities that were then sold. The industry has taken this cheap money and has drilled it into the ground.

This is one of the consequences of the Fed’s decision to flood the land with free liquidity. When the cost of capital is near zero, and when returns on low-risk investments are near zero as well, or even below zero, investors go into a sort of coma. But when they come out of it and realize that “sunk capital” has taken on a literal meaning, they’ll shut off the spigot.

Only then will drilling and production decline. As with natural gas, it can take years. And as with natural gas, the price might plunge through a four-year low and hit a decade low – which would be near $40/bbl, a price last seen in 2009. The bloodletting would be epic. To see where this is going, watch the money.

Worldwide, the balance of power in the oil business is shifting. Read… Oil Price Collapse Ricochets Around the World, Hits US Drillers, the Ruble … and Russia’s Probability of Default

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  15 comments for “How Low Can the Price of Oil Plunge?

  1. Mike Rains
    November 13, 2014 at 5:45 am

    I would not be at all surprised if down the road, it is revealed that fracking companies were provided investment monies from lenders that were “supported” to intentionally ignore the financial realities. In this respect, ‘”supported” means that assurances from very high places have been provided that if the financing ever blows up, no retribution will take place.

    Your well researched coverage of this new “industry” certainly indicates that many people are “looking the other way”, so to speak. Kind of reminiscent of sub-prime.

    Of course the justification/rationalization for this targeted support is clear: 1) Develop new energy resources within the country. 2) Create optimism to counter the doomsday prediction of peak oil. 3) Create lots of jobs.

    So I rather think that much of this uneconomic or marginally economical fracking has an invisible hand of support from the highest levels of our government. If ever revealed, it will be a lone insider and based on conversations or high level meetings. No smoking emails on this one.

  2. Julian the Apostate
    November 13, 2014 at 7:05 am

    If this is happening it is classic bait and switch. We all know the regime is putting into place the building blocks of a massive wealth transfer. Like all looters they operate strictly range of the moment, and count on their victims to “fix” it when it breaks. When this thing collapses we must withdraw our sanction and stop being battered spouses. This will be hard, because our nature as producers is to overcome obstacles. They cannot. They don’t know how. Their kind intersect reality at no point. WE have shielded them for too long. It’s time they face the consequences of their twisted souls. Only one word is required to bring down their house of cards. The word is NO!

  3. Vespa P200E
    November 13, 2014 at 9:36 am

    So Obola and Janet tell us the economy is humming along with low unemployment rate (with magical BLS addition of jobs out of thin air). OK whatever…

    Then why are prices of most commodities including gold on downward spirals? Maybe because under the surface there is general lack of global demand since the China’s insatiable demand was misallocation of cheap money and the Chinese growth engine is throttling back on bridges to no where infrastructures projects and ghost cities?

    As for oil price – I think some sparks may fly in the middle east beyond sabre rattling as low oil price is sucking the wind out of their economies )and more or less generous welfare state) as incident or 2 on Strait of Hormuz may do the trick. Chalk it to Iranians to start a spark or 2.

  4. NY Geezer
    November 13, 2014 at 9:40 am

    2014 is different. The cold war appears to have resumed. Several important governments and central banks are much more adversarial than in 2009.

    In war, whether cold or hot, nations seek to inflict maximum harm on their adversaries and are prepared to endure as much pain as it takes to win. There are too many oil producing heavyweights involved in the current conflict to make it comfortable to pick a bottom.

    I have difficulty comparing this oil market to 2009 which was a time when the parties that are in conflict today were cooperating, or appeared to be cooperating, to save the world economy.

    • Vespa P200E
      November 13, 2014 at 10:01 am

      Good point on cold war.

      I think Obola enlisted House of Saud to inflict some financial hurt to Russians whose hard currency comes primarily from oil and gas exports. Well be careful what you wish for with amateur Nobel peace price winner POTUS in power as trade sanctions, currency and trade wars may escalate to real wars.

      For example – historians say Japanese had to start a war with US as Japanese imported most of their oil from US (hard to believe but that was back in the late 1930’s) and US trade embargo and sanction blocked their sources of oil. US allies also refused to sell oil to Japan and thus they invaded Indonesia the Dutch colony with oil well (Dutch East Indies).

  5. Saylor
    November 13, 2014 at 10:30 am

    Could we be seeing the ‘long game’?

    I have through the years suspected that many of the moves of the U.S. Fed et. al. are not based in stupidity. We have many deep state think tanks who’s jobs are to ask ‘what if?’

    I’m not sure how this plays out against Asia (as in it can really help China), but energy producing countries are getting wacked by this drop. But I suspect there are those that were ‘prepared’ for this to happen or are receiving ‘life support’ to allow this to play out. A most interesting game board is before us. I see precious metals dropping but miners staying alive as lower energy costs will allow them to produce at lower costs over all

  6. limacon
    November 13, 2014 at 12:53 pm

    “A fierce price-war between Clathrate and Fracking energy production will drive the Petroleum price down to the $36-$72 per barrel range much sooner than previously estimated .”

    See
    http://andreswhy.blogspot.com/2013/04/petroleum-price-and-clathrates.html
    http://andreswhy.blogspot.com/2014/11/laundry-economics.html

  7. Petunia
    November 13, 2014 at 2:00 pm

    I thought the price of gas would go up the day after the election, and now that it hasn’t, I have been forced to give this some further thought. I’m certain they are up to something, but, what?

    Considering that now, a normal family budget is shelter, food, and transportation, at this point transportation is the only way to free up income to spend elsewhere. Are they trying to shore up retail spending in time for the holidays, possibly. But the savings aren’t enough to impact holiday sales significantly.

    Could the Russian Chinese gas deal be impacting demand for oil already? If it is having an impact this quickly then the price of gas will go a lot lower, as well as prices in general. No, that would never be allowed to happen.

  8. Orlando
    November 13, 2014 at 6:54 pm

    One would think this is parallel to 2008, where oil peaked as leverage began to leave for the hills. The full deleveraging then did not follow through as the FED started QE in November of that year and we haven’t looked back, until now. Now that QE is over, commodities are the first to deleverage again, since they ARE the MOST LIQUID investment, as compared to say real estate. How low can the price of oil go… well, the FED did not allow gold to leverage, flooding the market with gold whenever there were significant surges in buying volume. The gold standard traditional relationship between the two is 14 barrels of oil is equal to one ounce of gold or at todays closing price of 1159, oil should be at $82.00 . This could mean that oil is within the striking range of parity, or the price of gold will fall to catch up to the new equilibrium an implied increase in the value of the dollar. The Russians have been buying gold, 55 tons in the last six weeks according to reports. I suspect they have been trading oil for gold and they may have inadvertently caused the massive drop in price to gold parity to skirt the sanctions regime.

  9. November 13, 2014 at 9:09 pm

    Folks, meet ‘energy deflation’:

    http://www.economic-undertow.com/2014/07/25/the-great-question-mark/

    The dynamic is ‘energy deflation’, it is very similar to Irving Fisher’s ‘debt deflation’, there is the same positive feedback mechanism. With debt deflation, the more the borrowers repay, the more in real terms they owe because repayment removes funds from circulation. The vanishing supply of circulating money continually becomes more expensive, a ‘scarcity premium’ appends itself to the marketplace cost of funds. If the borrowers do not repay, then the assets become liabilities that the lenders themselves must retire … which they are unable to do for the same reason as the borrowers.

    With energy deflation, when the customer conserves — whether by accident or on purpose, it makes no difference — the remaining petroleum becomes more costly to extract in real terms. A scarcity premium attaches itself to the real cost of extraction for each new barrel of oil; the result is fewer available barrels as the scarcity premium per-barrel increases. At some point even a decrease in nominal price is exceeded by the scarcity premium.

    The only solution is stringent conservation … easy way or hard way.

    : )

  10. Julian the Apostate
    November 14, 2014 at 4:16 am

    Fascinating discussion. So the real world begins to intrude on the Keynesian fantasy. I have always said that the Internet is an Olympic sized swimming pool with an inch of water in it. This is not the case here. Thank you Wolf for the forum and to all the contributors for some really deep and thoughtful analysis.

  11. Rob
    November 15, 2014 at 12:05 pm

    So many examples of commodities that trade well below cost of production for long periods of time, yet people don’t seem to believe that gold can do the same.

  12. November 16, 2014 at 11:42 am

    Over the last few years the EU has lost a lot of its oil and gas suppliers,Libya,Sirya,Iran , Iraq the oil is being sold on the black market by ISIS and the supply of gas from Russia through Ukrain is not very reliable.All these have been self inflicted but this must make the EU dependent on very few suppliers which would make the price rise, eg If you think back to the sanctions on Iran for its nuclear program oil prices increased very quickly . Is demand for oil and gas very low,Or is low oil prices just another sanction on Russia?.

  13. Julian the Apostate
    November 17, 2014 at 10:49 am

    I see you’ve drunk the Kool-aid Rob.
    “Gold is money. Everything else is credit.” J.P. Morgan

    • Rob
      November 17, 2014 at 8:08 pm

      I buy things when they are unloved and sell them when every gun-toting bunker-dwelling conspiracy theorist on the planet starts pumping the hell out of them. If that’s drinking the Koolaid then please fetch me another glass.

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