Tuesday, August 02, 2016

Oil Caught in Vicious Circle

The price of oil on Tuesday closed below $40 per barrel for the first time since April. Rising oil supplies are putting downward pressure on prices once again.

Oilfield services firm Baker Hughes reported that drillers increased the number of rigs operating in U.S. fields for a fifth straight week.

Rising prices in recent months made drilling more economical than at the beginning of the year. However, increased drilling has also led to increased supplies.

The U.S. Energy Information Administration reported last week that inventories and production both rose, which is driving down prices.

You can see the vicious circle at play.

Oil companies are grappling with rising debts due to the collapse in prices over the past two years.

From 2010 through mid-2014, world oil prices were fairly stable, at around $110 a barrel. However, persistent oversupply pushed the price of oil down to $27 per barrel in February, before rising above $50 in late May and June. But the price fell back below $40 today.

This isn’t merely a problem for U.S. oil companies; it is also affecting entire countries that rely on oil for their budgets and economies.

Low oil prices have led to huge Saudi budget deficits, which led to near-record oil pumping, which led to greater supply, which led to even lower prices. It’s a vicious circle.

The Saudis, like all other major producers, are afraid of losing market share, so they won’t cut production. Iran has re-entered the global oil market after a long absence and Libya is not far behind.

Many oil producing countries are facing huge budget constraints and sinking economies. They simply can’t afford to cut production with the hope that it will lead to price increases. So, they keep pumping at breakneck speed, determined not to let other producers cut into their slice of the pie.

Even the OPEC-member countries — the global cartel for oil — cannot agree to production cuts. That’s raised an obvious question: If it’s every man for himself, what’s the point of the cartel? It seems to have lost its unity, power and effectiveness.

Some analysts now predict that oil will fall back to $35 per barrel this year.

This is happening even though Venezuela’s production has collapsed due to a crippling economic crisis. If Venezuela ever recovers its production capacity, who knows how far the price of oil could fall?

U.S. drivers won’t complain, though we’re now driving less than at any time in the last 60 years, according to a study by the Frontier Group:

The Driving Boom – a six decade-long period of steady increases in per-capita driving in the United States – is over.

Americans drive fewer total miles today than we did nine years ago, and fewer per person than we did at the end of Bill Clinton's first term. The unique combination of conditions that fueled the Driving Boom – from cheap gas prices to the rapid expansion of the workforce during the Baby Boom generation – no longer exists. Meanwhile, a new generation – the Millennials – sees a new American Dream that is less dependent on driving.

That’s bad news for oil producers and refiners alike.

Dozens of energy companies have gone bankrupt in the last couple of years. This has resulted in tens of thousands of layoffs in the energy sector (99,000 directly and indirectly in Texas alone) and billions in bad debt for the banks that backed them.

Law firm Haynes and Boone reports 83 energy industry bankruptcies have been filed since the beginning of 2015, with an aggregate debt of more than $13 billion.

Back in January, I wrote that all of the energy sector failures would ultimately result in bank failures, and the pressure has only mounted since then.

You can bet on this: energy companies are desperately working to service their debts and remain operational. So, they will keep pumping. Any momentary increases in the price of oil will suddenly make some idle fields and wells profitable to operate.

However, that will only lead to more pumping and increased supplies. Simply put, higher prices spur more output, which pushes prices back down again.

In a world that continues to struggle with weak economic growth, disinflation, deflation, negative interest rates and central banks actively devaluing their national currencies, demand for oil will remain weak, as will the price of oil.

All of this currency devaluation has served to strengthen the dollar and since oil is priced in dollars, oil prices will remain depressed.

In essence, a strong dollar has greater purchasing power, meaning it can buy more oil.

We are in a secular (long term) cycle of low oil prices, which is a boon to American consumers and drivers.

However, these are desperate times for energy companies and the banks that funded them.

It may be years before supply and demand are able to rebalance.

Yet, by that point, electric cars and renewables may have irrevocably altered oil’s hegemony in the energy sector, as well as its influence over our lives.