This is a topic that has been written about a million times already and many of you reading this will know most of the things I am about to write. However, for my friends who don’t follow the industry or never took a macroeconomics class, this is something I find interesting and therefore believe you will as well. I hereby declare a hearty “You’re Welcome” for publishing this article that none of you asked for[i].
Here’s the short version: Oil costs money to extract from a reservoir, and the amount of money it costs to produce varies wildly based on the oil reservoir location, physical properties, and method of extraction among other variables. Some of the world’s oil can be produced profitably at $20, but a lot more can be produced profitably at $100. The price point at which oil production shifts from a money loser to money maker is referred to as the “breakeven” price.
“Breakeven” price is often used to describe specific oil fields or types or even companies themselves. If more oil is produced than is used, usually due to higher production or reduced demand, oil inventories start to grow and the price of oil drops until inventory levels stabilize again. If oil prices are low enough, this stabilization can occur because oil producers simply shut off production from sources that have higher breakeven prices than the current price of oil. For example, a well with a breakeven point of $45/barrel may be produced when the price of oil is $50, but shut down when the price falls to $40 to avoid losing money. If enough wells are shut off that inventories return to normal levels, prices should stabilize around the new point.
Although how quickly production is shut down depends on how easily is it to stop and restart production and short term price projection, this drop in price will cause some of the oil production with the highest breakeven price to stop. This in theory rebalances supply and demand, stops the growing inventory, and stabilizes the price of oil. Well, in theory.
Alright, so that is the basics. Let’s look at some of the variables[ii] at play here. To keep things somewhat manageable, fort his post I’ll limit my scope to looking at oil cartels, increased production from fracking companies, inventory, and trading Impacts on oil price.
Price Fixing and Oil Cartels
Because of historic uncertainty around oil price due in large part to periodic flooding of the oil market with new production that caused price collapses, oil cartels such as the Texas Railroad Commission or the Organization of the Petroleum Exporting Countries (OPEC) have spent most of the last century trying to stabilize (or maximize, depending on who you ask) the price of oil by restricting member production to balance supply with demand. The word “cartel” generally has a negative connotation in the US because price fixing is a decidedly un-capitalistic behavior for private players. The activities of the Texas Railroad Commission on private producers were constrained to only prevent physical waste associated with improper extraction of oil and not allowed to impose production to prevent “economic waste” associated with price crashes[iii]. This role has fallen to OPEC for the last 60 years.
It would be an understatement to say that OPEC was not very popular with most people I knew in college in the mid-2000’s when oil prices soared and it began costing over $20[iv] to fill up gas tanks like the one in my 1992 Chrysler New Yorker. However, since oil is traded on the world market, OPEC’s imposition of production restrictions have provided assistance US suppliers by allowing them to produce at a much less restrained rate by preventing them from bearing the burden of price collapses that would have occurred had all oil producers continued seeking to maximizing their own output.
Of course, the US has long been a net-importer of oil and thus the maximized profits of these US companies has come largely from the hands of US consumers, but the profit has at least been disproportionately transferred to US producers over OPEC members as US producers. US producers have been rapidly eating away at OPEC’s access to the US market with the explosion of production that has occurred in the last few years. This is why OPEC decided not to cut production in 2014, to protect their market share against the rapidly growing US producers that would have benefitted from these cuts. By many accounts, this tactic to allow the price to crater to drive US production out of the market has not succeeded as well as OPEC had hoped, and they have since reversed course with a series of cuts that should continue through 2018.
Frackers Won’t Die
OPEC’s move was transparent, and while many small companies may have driven out of business by the move, many are kept afloat by their investors and continue to plug along posting loss after loss because a rebound in oil price would quickly erase those losses and them some. It also doesn’t hurt that there is a lot of extra capital in the world that people are desperate to put anywhere, inflating the value of stocks, housing, Snapchat, and whatever else might continue to rise in value[v].
The broader, non-oil market may or may not be about to crash, but the potential downside does seem to be growing relative to the upside. The same thing can’t necessarily be said about many smaller oil stocks, which can be had at a tiny fraction of what they cost a few years ago. A sudden swing in oil inventories, unrest in a major oil producing nation, or any number of factors could send the oil price back to 60 or 70 dollars, which would probably be enough to double or triple the value of some of these firms, especially ones that have found ways to more efficiently make production targets and chip away at their breakeven price. They could go to 0 as well, but that’s part of the fun I suppose.
As long as this extra production stays online, OPEC will have trouble balancing oil supply without continued output cuts. Additionally, as these companies get more efficient in how they produce oil and continue to grow their production and reduce their breakeven price, they could end up setting, and gradually lowering, a price ceiling in the oil market. The theory is that if there is a large chunk of production with similar per barrel production cost, the price will have trouble overshooting this production breakeven cost for long periods of time, if their supply ends up representing the key barrels of oil that causes global inventory increase rather than decrease or stay flat.
By the way, this is probably a good time to point out that I am right now (On January 19th, 2018) continuing a half-finished post, which based on the timestamp was last saved on June 8th, 2017. Since then, prices have turned around dramatically and as of this moment, WTI (US Marker Crude) is sitting at $63.45 per barrel while Brent (UK Marker Crude) is at $68.68 per barrel. As for my prediction with regards to price, most larger oil producing and refining companies have done very well in the last 7 months, but so has the overall market. Smaller companies that have taken on a lot of debt have not really double or tripled in stock price, although the value of their production has certainly increased. I suppose the market did a good job of pricing in the eventual turnaround in price, but the jury is still out for a lot of companies on how well the higher prices will allow them to emerge from their piles of debt. This seems like the part where I disclose that I own a small stake of Chesapeake Energy Corporation (CHK), which hasn’t yet seen its price rebound along with oil and seems to be constantly zipping along a knife’s edge when it comes to solvency (you can do it, buddy!).
Oil inventories is a word you hear a lot when hearing industry financial news. They serve as a buffer to differences between supply and demand, and because of this the quantity and rate of change in oil inventory becomes one of the key drivers of oil price as mentioned earlier. When more oil is used than produced, there is a drawdown on oil inventories to make up the difference, while inventories increase when excess oil is produced. However, because inventory represents actual physical oil in a location, different places can have different inventories and different ways of tracking it. Some have said that OPEC governments intentionally shifted inventory away from the US and to other countries because the US inventory is more rigorously tracked, while oil could hide in other markets. Additionally, there is quite a bit of floating inventory in the world, tankers loaded with oil wandering about while prices are low, although improving markets started to reverse this trend in late 2017. Of course, even poorly tracked inventory can’t hide forever, but any increase in oil price until it returns is free money in the seller’s pocket. Current world energy consumption is nearly 100 million barrels of oil per day[vi], which means that every day the price is increased by a dollar represents an additional $100 million dollars in profit every day. Stretch that one extra dollar out for a whole year and you can split and extra 36.5 billion dollars between the world’s oil producers.
Regardless of what is happening, the price of oil is going to be set by those buying and selling it. In 2007 when I was graduating college and oil prices were surging, oil speculators were a common bogeyman for people alleging price inflation. Although traditional economics would suggest that an efficient world market would consider all of off the important, publicly-known factors and dictate a price perfectly in line with those, weird things happen in the oil market and you end up with situations where oil reaches impossible to maintain highs (>$150/bbl in 2008) and lows (<$30/bbl in early 2016).
Before I talk about traders, I should mention something that makes the oil market harder than other. An Important factor driving swings in prices is the relative inelasticity of the demand curve for oil. That last sentence was full of pretentious business words, but think of it this way: Say you love Cracklin’ Oat Bran, which costs $3.89 per box at Target right now[vii]. Would you still buy that cereal if the price tripled to $12? OK, there’s not a great replacement cereal for Cracklin’ Oat Bran, so maybe you would, but overall sales would probably plummet immediately. However, if your car ran on Cracklin’ Oat Bran and you needed it to get to work, you probably wouldn’t run out and buy a car that used less Cracklin’ Oat Bran, or a new house that required you to fill up your Cracklin’ Oat Bran tank less often[viii].
To be honest, when gas prices skyrocket last, I didn’t even go out and check the air pressure in my tires, which was the go-to ‘helpful’ recommendation everyone tried to give for decreasing oil consumption. Sorry, saving 0.6% of my gasoline bill on average is not worth my time regardless of what the price is, try harder. Speaking of that…
Don’t even get me started on this nonsense.
So back to traders. Many oil traders are companies trying to hedge their bets to avoid a financial shock due to shifting oil prices. Though they can make quite a bit when prices shift suddenly, they can just as easily find themselves on the wrong side of that same trade. This means that while speculation can exacerbate prices, it’s not as if the traders are the ones reaping the reward at your expense. Instead, a lot of that money is traded between the people doing the trading, and the people that make the good (or lucky) trades end up making money from the people doing the bad trades, allowing you to rest comfortably with the knowledge that most of the money you spend at the gas station is still going to the good folks that get oil from the ground and into your car and not traders pushing money around. Or if you don’t work for a major oil company like me and you don’t really care why the price is dumb sometimes, at least you clearly have a lot of free time to get to the end of a long article like this one.
There’s a lot more I could write on oil prices, but this has already become a lot longer than I intended, and I should probably just post this before I get sidetracked for another 7 months and the market changes in a way that invalidates everything I said. Thanks for reading, let me know what you think in the comments.
[i] I assume if you clicked on this article you and I at least share some of the same interests, and there is scientific evidence that if you and I share the same preferences then you may also find this interesting. From the American Psychological Association 2010, Vol. 46, No. 2 Article entitled Children Reason About Shared Preferences, Christine A. Fawcett and Lori Markson from UC Berkeley explain:
In sum, the present study shows that by the third year of life, children are capable of recognizing another’s preference, determining whether that preference matches their own, and using this knowledge to make inferences about that person’s behavior to guide their own decisions.
Therefore, anyone who clicks this article and thinks that I am being presumptuous to assume you would find this interesting is either a liar or lacks the developmental maturity of most 2-year-olds.
[ii] I love using the word “variables,” it makes any analysis sound scientific and gives it the veneer of mathematical rigor, even when it’s dumb business garbage where people are basically trying to guess how much money a bunch of guys in New York can create out of thin air. As you can see, my grasp on basic business concepts is incredibly strong.
[iii] For more information on the Texas Railroad Commission’s efforts to restrict oil production to prevent economic and physical waste (as well as the entire history of oil) I would suggest reading Daniel Yergin’s The Prize. However, for those of you that don’t have time for an 800 page biography of oil there’s a very short version of the mission of the TRC here: https://www.tsl.texas.gov/exhibits/railroad/oil/page6.html
[iv] I began driving myself to high school after I turned 16, and my parents would reimburse me for one tank of gas a week. To maximize the amount I could drive I would let the tank get as close to dry as possible. I remember wishing I had printed a receipt the week my fill up cost $23 and my Dad seemed certain I was lying. Also, I’m guessing I had gleefully skipped into the house and informed him of this cost like a smug entitled jerk, which at 32 I now realize was probably the bigger issue.
[v] After spiking and crashing during the beginning of the great recession, S&P 500 price to earnings ratios have risen steadily for the past several years, gradually inflating the value of the companies in the index relative to the actual earnings those companies report (see http://www.multpl.com/table). People have used P/E ratio to say the market is overvalued for at least the last two years, but the money keeps flowing into the market. Although I say this is relation to almost everything, someone must know something I don’t.
[vi] U.S. Energy Information Administration (EIA) short-term outlook from January 9th, 2018: https://www.eia.gov/outlooks/steo/report/global_oil.php
[vii] Dang, I’ve actually paid $5.50 for a box of that cereal before, but mostly because I was bringing it to a buddy in Brazil who couldn’t find it there. $3.89 makes me want to go pick some up, but I digress.
[viii] I like not bringing the analogy back to oil directly, because the work Cracklin’ Oat Bran is pretty fun to read and write. Cracklin’ Oat Bran.