Despite Current Glut, Oil Producers Continue Game of Chicken

By Andy Tully, s a veteran news reporter who is now the news editor for Oilprice. Originally published at OilPrice

When the world gives you too much oil, drill for more.

That seems to be the motto of some of the most prolific oil producers today. Iraq, Russia, Latin America, West Africa, the United States, Canada – all may increase production this year, and by more than just balancing out the reduced production in war-torn Libya. On top of this, expect even more oil on the market if Iran comes to terms with the West over its nuclear program and is freed of the constraints of sanctions.

That’s the conclusion of Adam Longson, an oil analyst at Morgan Stanley writing in an e-mailed report on Jan. 5.

All this new oil is flooding a market already awash because OPEC has refused to cut its production cap below 30 million barrels a day – and is even exceeding that level – and the United States is pumping oil, mostly from shale, faster than it has in 30 years. This has caused the average price of oil to plunge more than 50 percent, from about $115 in June 2014 to just over $50 today.

This is creating an unmitigated bear market for oil, according to Morgan Stanley. “With the global oil market just passing peak runs and Libyan supply already at low levels, it’s hard to see much improvement in oil fundamentals near term,” its report said. “A number of worrying signs have already emerged, lifting the probability of our ‘bear’ case.”

One more sign is that Iraq’s production is at its highest level in more than three decades, now that Baghdad has finally reached agreement with Kurdistan to allow it to export oil through Turkey. And just before the New Year there were reports that Russian oil output has hit post-Soviet records without any sign of abating.

“We already have an ample supply of oil, and on top of that we see this increase from Iraq and Russia,” Michael Hewson, analyst at CMC Markets, a British financial derivatives dealer, told The Wall Street Journal. “The momentum clearly continues to be bearish for oil.”

But wait, there’s more, according to the Morgan Stanley analysis. It says to expect increased production at several oil fields in Brazil, Canada, the United States and in West Africa. And, according to Hewson, there’s no sign of increased demand, according to reports of anemic economies in China and Europe.

And then there’s the environment. The governments of many countries – including the world’s two hungriest fossil fuel consumers, China and the United States – are striving to meet various targets for lower greenhouse gas emissions. This new green approach is responsible for “anemic global growth” in demand for oil and an “upsurge in competing supply,” said David Hufton, the CEO of the broker PVM.

“[It] is very plain for all to see that oil supply growth exceeds oil demand growth and from an oil producer point of view, this imbalance has to be rectified,” Hufton told the Financial Times.

Carsten Fritsch, a senior oil and commodities analyst at Commerzbank in Frankfurt, agreed. “The easiest path for oil is down,” he told Reuters. “Almost all market news and the fundamental backdrop are negative, and it is difficult to see much upside at the moment.”

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33 comments

  1. Clive

    I’ve been quite amazed by the over-simplification which has been going on in financial press about the implications of the oil price fall. It seems bizarre that such a well-informed (or, at least, they should be well informed) set of pundits can apparently fail to grasp the very basic concepts of how investment works, how capital is formed, what an industrial project means in terms of certain stage gates which — once passed — cannot be easily or cheaply rowed back without losses, what the creation of an asset through this investment means in accounting terms and how that asset is valued based on the projected returns on that asset. It is textbook stuff. So the readings into current events which end up concluding “oh, it’s all going to be okay, producers will just stop producing for a while and everything will pan out according to the same parameters that were in play a year ago” get back from me a clear reply of “No”. That is simply not how it works. The fact the some commentators are trying to pretend it is makes me wonder about their motives for the Rebecca of Sunnybrook Farm interpretations they are proffering.

    Let’s take capex spend committed for these approvals by year for the UK oil industry:

    https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/385244/Chart_Showing_Capex_Spend_Committed_for_Field_and_FDP_Add.pdf

    So, £30-ish billion has been sunk — spent, the money has been paid out — into relatively new oil production capability creating assets which were, presumably, since investment decisions are made with the intention of creating an asset which exceeds the cost of creating it by some margin within the past 5 years. Now, each investment decision was slightly different and minor variations would have been assumed in the cost of production vs. the assumed prevailing oil price. But I can pretty much guarantee that none of the business cases would have included an oil price much below $80/barrel for any sort of extended period. And anything below $50/barrel would have seemed laughable. If these low oil price assumptions had been made, the business case would not have been viable and the investment would not have been made.

    The investors who put up the £30bn of capital are expecting a return of whatever-%. At the very — very — least, they cannot get the return they were expecting and the income from the productive asset will be less than was assumed. A blip of a, say, $20-30/barrel oil price reduction for a single quarter could would have relatively little impact. But you can’t suffer a reduction of 50% in actual income vs. assumed income without having to conduct an asset impairment. The asset certainly isn’t worth zero. But it simply cannot be treated as retaining “book” value over the accounting lifespan (say, 10, 20 or maybe 30 years) of the asset’s life. You can tweak the depreciation of course, to reflect the longer anticipated economic lifespan of the asset (the oil production facility or well) but you still have to factor in the reduced income stream in the near term.

    In conducting an asset impairment review, asset owners, investors and lenders will need to work out whether it is better to stop production, reduce production or keep producing at the same rate in the light of a complex set of variables such as the cost of mothballing (you can’t just down tools from an oilfield overnight), the cost of maintenance to keep the asset production-ready, the cost of debt service, the income you expect in 6 months, 12 months and 2 years. Just getting all the impacted parties round the table, resolving the inevitable conflicts of interests that each one has, coming up with an agreed decision then implementing it, literally, “in the field” is not a quick or easy job. In the meantime, whatever the current operations of the asset is, it will have to continue because if it is to change, the interested parties have to work out how they want to change it.

    The trouble is, people who work in finance (myself included, it takes a lot of effort to think outside your own box) are so far removed from the real, actual, productive economy and industry they think it’s all just a matter of running some numbers in a spreadsheet and, hey-presto, that’s what reality will become. Erm, nope.

    1. Jim Haygood

      ‘The trouble is, people who work in finance are so far removed from the real, actual, productive economy and industry.’

      Those who aren’t will reach the obvious conclusion: there’s never been a better time to buy a V-12 automobile.

    2. Jim McKay

      Nice, detailed explanation… appreciated. Spoken from POV of honest/ethical accounting.

      Problem: these guys have a way of finding means to transfer losses to “non-interested” parties. When reality of their investment becomes vividly clear they will lose $$, they begin also “thinking outside the box” as you say… not for means to shut down/maintain wells and such. Rather, twist political arms for accounting rule changes, wrap assets in some type of masked bond., or any one of multitude of unimagined “Enron” type mirages.

      1. QuarterBack

        Speaking of transferring losses, have you noticed the enormous spike in Bloomerberg Radio ads offering “qualified investors” the “opportunity own” a “productive” (I.e. Pumping oil – if not actually making money productive) U.S. oil well? Interesting too how the talking points of these ads are only accurate in the period before oil started to retreat from $100 per barrel. They are practically as believable as the Nigerian prince phishing emails.

    3. TheraP

      I think what you’re describing is the mindset of a gambling addict, someone who’s wedded to a fantasy and can’t stop believing the fantasy will come true. Every market has its fantasists. We’re watching madness in action.

      Whatever the asset, some sellers seem unable to cut their losses and move on. And in other cases, like the frackers, they’ve painted themselves into a corner their gambler fantasies never envisioned.

      Mind you, I’m no economist, so I can only stand on the sidelines both horrified and transfixed. At least if it were a crazy person we could remove them from the railroad tracks, despite their belief there was a pot of gold buried there.

    4. Whine Country

      The trouble with this, the trouble with that, the trouble, the trouble… The trouble is that all of these players are acting perfectly rationally. Why would anyone quit pumping when the person making the decision would immediately lose his or her income. And why would you quit pumping when any losses will be either born by some other individual (or institution) or most likely the taxpayers. These people are real people and make rational decisions everyday according to the facts before them. We allow the creation of the wrong incentives and we get what we have now. The real trouble is, We have met the enemy and he is us. Us, who enable those people to do what they do. A cartoonist named Walt Kelly wrote this many years ago. The underlying tone of most comments on this is that the players are somehow foolish or worse. If there is no downside to keeping on pumping, why would anyone elect not to?

    1. Yves Smith Post author

      With conventional oil, you just keep it in the ground but the frackers need to keep pumping to generate cash flow to service debt.

      1. Synapsid

        Yves,

        Yes.

        And once a well has been fracked it must be put into production; before the fracking it can be drilled, cased and cemented, and then left (under care), but not after fracking, as far as I know.

  2. Nell

    The quote by David Hufton may well be a sign of things to come.
    “[It] is very plain for all to see that oil supply growth exceeds oil demand growth and from an oil producer point of view, this imbalance has to be rectified,”
    If Nitzan and Bichler’s (1995) analysis is right then we may be seeing conflict and war in the near future. In 1995 they published a paper showing that conflicts in the middle east can be predicted by the differential return on equity between the core petro-companies and the fortune 500 companies. When the petro-companies are trailing the average a crisis erupts. Following the crisis the petro-companies return on equity beats the average. Presumably, the drop in oil prices will hit the return on equity for the core petro-companies. Recently, Nitzan and Bichler updated their model and the only conflict their model did not predict was the 2011 Arab Spring.
    http://rwer.wordpress.com/2014/12/11/energy-conflicts-and-differential-profits-an-update/

  3. Nik

    “And then there’s the environment. The governments of many countries – including the world’s two hungriest fossil fuel consumers, China and the United States – are striving to meet various targets for lower greenhouse gas emissions. This new green approach is responsible for “anemic global growth” in demand for oil and an “upsurge in competing supply,” said David Hufton, the CEO of the broker PVM.”

    Don’t tell me the burden of disproof for this drivel is on us. Decades of efficiency improvements and environmental campaigns, and the last eight years of relatively astronomical prices have failed to reduce overall consumption, but now a spot of handwaving is sending it into the ground? Hufton wishes for a problem so simple…

    1. Jim McKay

      “Don’t tell me the burden of disproof for this drivel is on us.”

      Completely agree.

      “This new green approach is responsible for “anemic global growth” in demand for oil and an “upsurge in competing supply,” said David Hufton, the CEO of the broker PVM.”

      Hard to reconcile how boom in US Dakota/fracking production & Canadian shale was driven by a “new green approach”.

  4. Luke The Debtor

    US could add 2 million barrels of oil without drilling a single well by allowing the XL pipeline to be built and lifting sanctions against Iran. The US could also do away with the Jones Act and other oil exporting restriction, but even with a “free market” conservative-minded Republican majority congress, that will never happen.

    So far most layoffs in the US have been confined to oil companies and service companies. However, US Steel announced over 700 layoffs.

    1. weinerdog43

      Um, oil is fungible. There is no guarantee that said oil wouldn’t be directly offloaded on to Chinese oil tankers. But the dirtiest oil on the planet would indeed create 50 permanent jobs, so there’s that.

    2. TedWa

      And nevermind that the Ogallala aquifer could very likely be polluted beyond any clean up attempts. Say goodbye to America’s breadbasket for 35 jobs with all the risks put on American taxpayers for oil company and Canadian profits.

    3. Yves Smith Post author

      XL is heavy distillates. It is not fungible with other types of oil. Iran is also heavy distillates and therefore high cost product.

      The last thing the world needs at this minute is more output, particularly of high cost product.

  5. ThePaper

    So if someone wanted to save US oil production where would you destroy oil production? I don’t see Iraq viable without a major external invasion, most of the oil production is safe in the South. Perhaps a full war on Iran? That’s 2m to 3m. How large is the current overproduction? Russia? It would take more than a simple frontier war or economic crisis to reduce pumping there.

    Perhaps the faster and most explosive way to destroy a large amount of oil production and getting oil prices back to the Moon would be triggering the Saudi Arabia civil war.

  6. Whine Country

    It’s called malinvestment and it is inevitable when you have a heads I win, tails you lose environment such as the Fed and its allied politicians have created. (Technically it’s privatized gains and socialized losses along with unregulated and subsidized capital markets.) We should be surprised only that we are surprised when this happens! One persons asset is always another persons liability. We want to pretend that the asset that is worthless (or “impaired” as they say) is not, so that we continue to decree that the corresponding liability is still valued at par. And for what? To basically keep a small class of people from losing some of the wealth that they could not possible need or spend in their lives. (Well, there’s the banks and the banksters too.) Gogle Luca Pacioli and see what comes up. The idea of double entry accounting was first discovered two years after Columbus came to America. Of course, we’ve improved on his work so much since then. We have no less than lost our ability to govern ourselves while at the same time we argue about everything but that.

  7. Jackrabbit

    What were the analysts saying 6 months ago? I’ll bet drillers were getting financing in September, maybe October.

    Why didn’t Saudi Arabia whack the “tight oil” producers years ago?

    Clive’s comment agrees with Arthur Burman’s: that the “tight oil” producers will pump their current wells for many months but can’t raise financing to drill more wells if oil prices are in the low 80’s. Knowing that, wouldn’t have made more sense for the Saudi’s to listen to the pleas of fellow OPEC members and set a price target of about $80? Why lose more money than you have to?

    It seems that anything about $80 targets countries pumping traditional wells, not the “tight oil” producers – but the countries hit hardest are the sanctioned countries: Russia, Iran, and Venezuela.

    =
    =
    =
    H O P

    1. Jackrabbit

      anything below about

      =

      Also note: If stabilizing at about $80 could have been accompanied by a Saudi’s/OPEC warning that prices could go lower for good measure. No more financing for “tight oil”. And maintaining $80-ish oil for the long term is easier than sub-$50’s.

    2. Yves Smith Post author

      Conditions were not right. Much easier to do much more damage when demand is weak. China was still growing strongly two years ago and Europe was in less bad shape.

  8. j7915

    Saudi Arabia is essentially the House of Saud. They could probably get by on a feww billion in revenue per year. However they have to pay for bread and circuses to keep the population from getting restless.

    What happens if ISIL convinces the saudis that the rulers are giving the “peoples oil” away for way too little and to infidels none the less? As mentioned above, civil war? Who has the allegiance of the public, the House of Saud or the radical imans?

    1. Generalfeldmarschall von Hindenburg

      Well that’s a timely question. The Saud family has put the radical imams in their place at least twice in the country’s history. I think it’s safe to assume they feel confident they can shorten the leash of the clerics whenever it’s necessary. But elites do miscalculate.

  9. PNW_WarriorWoman

    Working on a theory. When do you remember our gas prices dropping so quickly? I don’t remember it before the November election. If you were the President facing your final two years where your only action would be on the international stage and you needed one magic lever to pull to hit Russia, Iran and Venezuela in the chops AND assure the delay of Keystone with a GOP controlled congress AND cripple shale oil drillers because it’s all bad for America, AND create an energy price market in the short term to help a future Dem candidate, what would you do? Well I know what I’d do. I’d be strategizing in the summer for this outcome, lining up the supply support of my Saudi client and be ready to telegraph to staffers in MY White House that it would be a wonderful miracle if the price of oil dropped fast, hard, and stay low until I moved out in two years. Is there any possibility the GOP is secretly thrilled because they know heartland voters don’t want Keystone either? Everyone gets cover? Too much tin foil hat in this theory or plausible?

    1. Yves Smith Post author

      *Sigh”. It is the fall in Chinese and European demand that led to the oil price plunge. Oil prices are very sensitive to demand. Look at how oil went from $147 a barrel to $60 a barrel in 2008.

      Please stop with this sort of conspiracy theory. This isn’t even good CT, since the Dems got slaughtered in the mid-terms.

      1. Generalfeldmarschall von Hindenburg

        Yeah. I don’t see demand in the EU or China skyrocketing anytime soon either.

      2. likbez

        I think all this futures and derivatives games around commodities make oil prices less sensitive to demand and more sensitive to financial manipulation. I wonder how sensitive are oil prices to HFT games. Look at volumes of OIL ETF for the last year.

  10. c1ue

    One possible silver lining: this will serve as a potentially useful example to see what differences there are between $50B/year in profit from top level production injected into the US economy vs. a similar amount injected into consumer wallets – in terms of jobs and economic growth.
    Or in other words – all the money that was formerly trickling down through the production chain vs. money that’s going to be directly spent by consumers on mostly foreign stuff.

  11. steelhead23

    First, it is silly to think that production could turn on a dime. Until the price of oil drops below the marginal cost of production from existing developments (excluding sunk costs) it will continue to be wise to produce. This may not be true of large sovereign producers like SA and OPEC as they could affect price by reducing production. But for most producers, their production is too small to greatly affect the market – and there are bills to pay – pump away! The real slowdown will be in exploration and development. Let me posit one more time that this situation, where debt-service and the unattractiveness of investment in the oil patch is causing a death spiral of smaller, more indebted companies, is a result of stupid corporate governance. Specifically, oil companies are broadly resource rich and cash poor. In recent years they have tended to sink profits into stock buybacks and dividends (“maximizing shareholder value”), leaving themselves vulnerable to what would otherwise be temporary cash flow problems. That is, were the companies to have fat bank accounts, they could slow production when prices drop and keep their resource in the ground with the expectation that they would be worth more later. But no, many have debts that exceed annual revenues and if they wish to hold onto their assets, must sell oil at depressed prices to meet their debt burden. I expect a number of oil companies to go bankrupt in 2015. Thank you very much Milton Friedman.

  12. mike

    This oil situation just proves to us all how and by how much we’ve getting f#@#$ed all these years. If three countries including Saudi Arabia can make money at $20/barrel then keep pumping and flood the market. Opec has only worked till now because it’s has just been another market manipulation. Leave the oil business to the natural market forces and the world and the markets will adjust. If 75% of producers die then so be it. After realizing that money can be made at $20/ barrel, and with ample supply, do you think people will once again willingly pay $100 barrel?? All markets have been fixed and manipulated , and opec was probably the first one to be initiated but one of the last to be exposed.
    The end is here! Put on your seat belts. We are all to experience a market “religious experience”. We don’t get what we ask for..we get what we deserve!

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