Note on the Current Global Oil Market

By


Saudi Arabia Oil Minister
U.S. Oil Production

Energy prices could go up at the same time that energy production could continue to decrease, although not as much as simple supply/demand forecasts would expect (see prior post).  Crude oil prices would have to rise from current $35/barrel level to at least $50/barrel to stabilize production and over $60/barrel to start increasing production.  Similar percent increases would be needed for natural gas.

For most shale oil and natural gas producers, virtually all operating revenue is now going to debt payments.  After hedges come off, the number of bankruptcies and “distressed debt” will accelerate in second quarter of 2016.  The companies can continue production but bondholders, lenders and stockholders will suffer even larger losses.  This trend has already started in the junk bond market and the fall of public oil companies’ stock prices.

Why Saudi Arabia Misjudged U.S. Oil Production

While OPEC countries produce 40% of the world’s oil, there is no consensus on policy.  Just the opposite.  There are deep rifts between countries, as discussed in earlier posts. 

Saudi Arabia and its allies believed that all-out production would quickly create a global glut, falling prices and a sharp cutback in U.S. and Canadian production.  Unlike most countries, American oil is produced by private companies that have to worry about profits and meeting debt obligations.  But over the last year, U.S. oil production has stayed high and is only now beginning to decline.  This has occurred even though the number of drilling rigs has decreased.  What the Saudis misjudged was that American drillers adapted to lower prices by shutting down low-producing wells, using new technology to increase output per well, reducing drilling costs by drilling deeper faster, and forcing suppliers to reduce their prices to producers.  Breakeven prices came down.  However, at $35/barrel, virtually all drillers are losing money.  More and more are having trouble meeting debt payments from operating income.  In the last two weeks, three junk bond funds have folded, mostly because of losses on energy junk bonds.  Total oil production is starting to decrease.

One reason that American oil production stayed at higher levels than the Saudis expected is that when oil prices began to go down in late 2014, many drillers hedged part their production.  This means that they locked in prices higher than the declining market (spot) prices.  Revenue was higher than forecasted just from looking at market prices. 


If I Were the Oil Minister of Saudi Arabia

There is still too much global oil production as inventories continue to build up.  There is an estimated 30 billion barrels of oil in inventory, about 33 days of consumption.  The only growth sector of the oil industry is the building of storage facilities.  Some oil is being stored on tankers at sea. 

Price increases will lag any production declines as inventory is worked down.  Global production will probably have to decrease by at least 2 million barrels per day for some time before supply comes back into balance with demand and prices rise, even if global demand is stagnant.

As Saudi oil minister, I would continue all-out production.   Most of the American hedges expire in the fourth quarter of 2015 and the first quarter of 2016.  By the end of the second quarter of 2016, the financial condition of American drillers should be critical.  More drillers will declare bankruptcy.  But again, the decrease in production will be less than forecasted.  By declaring Chapter 11 bankruptcy, drilling companies can continue in operation without the major cost of debt expense.  Companies will merge and assets will be sold.  Even given this, the Saudis can probably expect total U.S. and Canadian production will decline by about one million barrels a day.

Besides Saudi Arabia and its allies, a number of other countries both within OPEC and outside OPEC would also like to decrease production.  Prices would rise but only if other countries did not raise production to take away market share. 

With inelastic demand, the percent reduction in total output would be less than the percent increase in price.  Total export revenue would increase.

If I Were Vladimir Putin

While a number of countries might be willing to make a small percent reduction in production, the two wildcards are Russia and Iran.  Russia and Iran, as supporters of the government of Syria, are geopolitical rivals of Saudi Arabia.  But another year of low oil prices would put serious strains on the domestic economy and the government finances of Russia.  President Putin might calculate that the political risks of continued low oil (and related natural gas) prices are too high.

Russia, one of the three largest oil producers, might keep production high for domestic political reasons and “free-ride” on a global price increase.  Iran, recently released from economic sanctions, has announced planned increases in production.  Russia might work out a long-term deal with Iran that would have economic and geopolitical benefits.  Russia would slightly cut back production (about 2 1/2% to start) and buy Iran’s increased output as a substitute and resell it to Europe.  Over time, Russia’s older fields would have declining production and Russia would abandon plans for very expensive (and unprofitable) Arctic exploration projects, which relies on Western technology.  Instead, Russia would buy increasing amounts of Iranian oil.  In exchange, Russia would build more nuclear power plants in Iran and supply Iran with uranium (and arms).  Russia and Iran have already agreed to the first steps of a nuclear power plant deal; it could be expanded as Iran sells more oil to Russia.  Both Russia and Iran would benefit from higher global oil prices without an explicit deal with Saudi Arabia.

Conclusion

Global oil production has to fall by about 2 million barrels/day from its current level of around 92 million barrels/day to work down inventories and increase prices.  By the middle of next year, half of the decrease will come from the U.S. and Canada.  So the rest of the world only has to decrease production by 1%-2% for prices to eventually rise.  A price increase to the $50-$60 range – 40-70% from the current benchmark prices - would greatly increase the hard currency export earnings of all oil exporters and probably not lead to production increases in the U.S. and Canada.

This seems like a no-brainer.  But will it happen?  A game theorist familiar with the Prisoner’s Dilemma would be somewhat doubtful.  These are not the purely rational players of game theory.  Despotic political leaders and their political elite more concerned about staying in power and other domestic concerns head many of these countries.  Some are also geopolitical rivals, often with an overlay of intense religious or historical animosity.  And virtually every OPEC member has a history of cheating on production quotas.
==================================================================

A number of prior posts discuss these themes in more detail.  See the recent post on Saudi Arabia.












Comments

Post a Comment

Most Popular Posts

Adam Smith's Pin Factory

By
Image
Adam Smith - Our Founding Father ADAM SMITH VISITS A PIN FACTORY   Adam Smith’s description of a pin factory is on the first page of  The Wealth of Nations .  (Chapter 1 – “Of the Division of Labour”)  Drawings of pin factories of this period show workers using hand tools. Smith says the process can be broken down into 18 distinct steps, including packaging the pins. Smith mentions that pin factory workers were poorly paid, despite their high productivity.    Adam Smith says he visited a pin factory employing 10 men who produced 48,000 pins per day.  If each of the ten workers had done all the steps themselves, Smith says each worker could produce only 10 or 20 pins per day.  So the pin factory replaces 2,400 to 4,800 pin makers. The increase in labor productivity (output per person per day) is as high as 50 times that of individual pin makers.     This reduction in unit cost or average cost (AC) and the huge i...
Read more

Bilateral Oligopoly

By
Image
The best movie about the Gunfight at the O.K. Corral is titled My Darling Clementine. A great western - great cast, great photography.  DEFINITION OF A BILATERAL OLIGOPOLY Models of market structure assume that the demand side is represented by a large number of buyers.  The structure of the market, and the assumed market outcomes, depends on the number of suppliers and how they compete.  Suppliers either post one price or exploit their knowledge of buyer categories by using price discrimination.  Despite the comments about the key role of consumers in determining economic performance, consumers are fairly passive when the discussion focuses on imperfectly-competitive industries.  But many markets are not structured this way; the buyers are not passive consumers but large corporations that do not passively accept suppliers’ prices.  Net prices are actively negotiated.  These markets are often bilateral oligopolies. In a bilateral oligo...
Read more

The Stock Market Crash of 1929 and the Beginning of the Great Depression

By
Image
Famous Headline Before You Begin If you don't know the background of this complicated story, you might want to first read a shorter version that introduces some of the key factors explaining the Crash and the Depression. See, Introduction to the Stock Market Crash of 1929 and the Beginning of the Great Depression Before reading this essay, I strongly recommend you see the PBS video on YouTube. Type in Stock Market Crash 1929. Look for US – The Crash of 1929 (PBS), ALLHISTORIES – PLAYLIST.  Documentary broken into 6 parts to show commercials. Or buy the video on Amazon Prime. Great documentary with wonderful photos, videos, and scenes from movies of the 1920s and the crash. Shows what a crazy time it was. The video is also a great introduction to Andrew Ross Sorkin, 1929:  Inside the Greatest Crash in Wall Street History - and How It Shattered a Nation.  This book concentrates on the roles played by a small number of key men; the video also focuses on these me...
Read more

List of Posts By Topic

By
Image
FIND POSTS BY CATEGORY The Beginning of the Industrial Revolution The theme of the following four sections of the blog is that innovation, not price competition, is the basis for understanding economic growth, competition, and analysis. Basic Concepts and Theory Market Behavior and Structure Market Dynamics and Information:  How Markets Work Economic Theory and Markets Corporate Strategies There is beginning a historic change in future populations and their demographics. This will interact with other variables and have a serious, maybe profound, effect on future economic growth. Demographics and Economics China Geopolitics and the Global Economy American Economic History Management The world seems to be in the midst of radical political and social change. Where are we going? Can studying past periods and countries facing disrupting change help us navigate our times? Maybe. History American History World War I:  The Beginning of the 20th Century The Roman Republic and Amer...
Read more

Government Finance 101. Fiscal Policy: Welcome to Alice in Wonderland

By
Image
Secretary of the Treasury PRELIMINARY SUMMARY OF FISCAL YEAR 2025 BUDGET   The Congressional Budget Office (CBO) made their latest projection in January, 2025. The projected deficit in fiscal year 2025 will be around $1.8 trillion, the difference between about $5.2 trillion in revenue and $7.0 trillion in expenses. Interest on the national debt this year will be around $950 billion, over twice the interest expense in the fiscal year 2021 budget and equal to the defense budget. By 2035, the CBO expects the  yearly  budget deficit to increase to $2.7 trillion.   Interest expense this year passed budgeted outlays for the military. It is about equal to Medicare, and also to total non-defense discretionary spending.   Leaving aside Social Security and Medicare, interest expense is  about 20% of total budget outlays. Interest expense is about half the budget deficit.   The $1.8 trillion budget deficit is 6-7% of total GDP, or approximately 10% of consume...
Read more

Explaining Derivatives - An Analogy

By
Image
You go around to farmers with cows. You buy all the cows and pay the farmers a small fee to milk the cows and sell the milk. You pay for the cows with ass(et)-backed securities called MBSs (Milked Bovine Securities) that you tell investors are udderly safe. But some of the cows don't give enough milk (cow flow problems) or give no milk at all. You take some of the asset-backed securities, say they're backed by the subprime cows, and use them as collateral to sell another set of securities called CMOs (Cow Milk Obligations). Then you buy CDSs (Cow Dried-up Swaps) from AIG (Angus Insurance Company) to insure the CMOs when the cows stopped giving milk. If you work it right, you collect more on the CDSs than you pay out to retire the CMOs. The money you get from selling the dead cows go to pay the CLOs (cow leather obligations). You could also sell CDOs (cow dung obligations) that depend on how much cow dung is produced. This is a typical Wall Street product - turning s...
Read more

Josiah Wedgwood, the Wedgwood Pottery Company, and the Beginning of the Industrial Revolution in England

By
Image
Wedgwood Anti-Slavery Cameo A better introduction to the beginning of the Industrial Revolution than Adam Smith is the history of Josiah Wedgwood and the Wedgwood Pottery Company. This is how one company actually ushered in the Industrial Revolution. The revolutionary generation that first adopted steam engines saw the following trends and changes: Manufacturing was being modernized by a small group of entrepreneurs. Much of the new raw material processing and manufacturing was concentrated in a small area in the middle of England, away from London. These modernizing entrepreneurs formed a new economic, intellectual and social network. Modernizing entrepreneurs like Wedgwood tended to be members of Dissenting sects (like Quakers) or Nonconformist churches (not members of the Church of England), Whigs (liberals) in politics, and believers in “progress.” They were optimistic about the future, influenced by the ideas of Hume, Rousseau, Locke and Adam Smith. They believed...
Read more

John von Neumann Sees the Future

By
Image
John von Neumann JOHN VON NEUMANN CREATES THE FUTURE If you want to understand the world we live in, you have to know about the thinking of three men – Alan Turing, Claude Shannon and John von Neumann.   I’ve talked a little about Alan Turing in an earlier essay.   All three men knew each other, discussed their thinking with each other, and promoted each other’s ideas. John von Neumann has been called the smartest individual of the 20 th Century (by his brother-in-law, who won a Nobel Prize in Physics).   A n outline of von Neumann's accomplishments, which you can read about in  Wikipedia, is hard to believe.   He invented game theory, which I discussed in two earlier posts.   He belonged to a group of mathematicians who invented new statistical techniques at Los Alamos that made the atomic bomb possible. He invented game theory. In 1944, he wrote a memo that outlined the structure of the modern computer.   He then managed the design a...
Read more

The Roman Republic Commits Suicide: A Cautionary Tale for America

By
Image
Roman Legion Why Study Rome? Americans have focused on comparisons between Rome and America twice in American history.  The first time was during the period from before the Revolution to after the ratification of the Constitution and Bill of Rights, when the founding fathers and others looked to the Roman Republic for ideas and inspiration on how to structure the new government. After the American Revolution, the founding fathers, having read the Roman authors detailing the collapse of the Roman republic, worried about internal threats to the survival of their new republic.   The second time was when the United States became a superpower, especially after WWII, and then again after the collapse of the Soviet Union in 1991. Commentators compared America to the Roman Empire at the height of its power. There was some discussion about how America became a permanent warfare state and how it affected domestic democracy and civil society. ...
Read more

The English East India Company (EIC): Trade with Asia

By
Image
The Mughal emperor Shah Alam hands a scroll to Robert Clive, the governor of Bengal, which transferred tax collecting rights in Bengal, Bihar and Orissa to the East India Company.  Illustration: Benjamin West (1738–1820)/British Library INTRODUCTION   The English East India Company (EIC) was an innovative new type of corporation. It is a model for the modern limited-liability, stockholder-funded modern corporation. The EIC also illustrates that the prototype of the modern multinational corporation was created to develop global trade.   HISTORIC BACKGROUND   The creation of the English East India Company (EIC) and its Dutch equivalent (the VOC) were part of the 400-year expansion of European power, trade, and influence. Much  of the rest of the world became colonies, part of imperial empires. By 1600, both England and Holland had a wealthy merchant and shipping class, bankers, substantial liquid capital (wealth) not tied up in land, and risk-takers. These categor...
Read more