Why Are The Oil Markets Crashing?

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We pointed out in late 2014, citing the work of the Financial Times’ John Dizard, that it was access to money, and not fundamentals, that would (as in could in theory) constrain US shale gas production. As you can see below, that has yet to happen. And OPEC hasn’t turned off the spigot either. From a 2014 post:

In the new normal of lower energy prices, developers are apparently playing a game of chicken, hoping that competitors will cut production first. Dizard again:

Particularly in the gas and natural gas liquids drilling directed sector, every operator (and their financier) is waiting for every other operator to stop or slow their drilling programmes, so there can be some recovery in the supply-demand balance. I have been hearing a lot of buzz about cutbacks in drilling budgets for 2015, but we will not really know until the companies begin to report in January and February. Then we will find out if they really are cutting back, using their profits on in-the-money hedge programmes to keep their debt under control, and taking impairment charges on properties that did not really pay off.

One gas-orientated industry man in Houston I know thinks that the banks are going to call a halt to the madness of permanent negative operating cash flows. “What is the timing of their borrowing base renegotiations (with the banks)? That is the most important thing; can they borrow more money?” If not, he believes drilling and producing on uneconomic terms will slow or stop, and with the high depletion rates of unconventional reserves, such as shale gas, supplies will fall and gas prices will rise.

In other words, if the industry doesn’t discipline itself, the money sources will. Or will it?

If the bankers reduce the borrowing base for the E&P companies, there could be a lot of private equity or high-yield investors with covenant-light deals to offer who might take their place. Not to mention cash-rich majors who would like to take the billions they can no longer put into Russia or Venezuela, who would not mind picking up more North American properties on the cheap.

Although Dizard does not discuss the downside directly, he sets forth a fact pattern that could lead to some ugly ends. US shale gas production needs to get to $6 per mBtu or more for players who aren’t very leveraged to get to break-even cash flow; they hope to make more two to three years after that on presumably higher prices.

But if super low interest rates keep money flowing into the shale bubble, another set of issues emerges: US production is set to considerably outstrip domestic uses:

So much gas is being developed in the Marcellus and Utica resources of the northeastern US that it really cannot be absorbed by the US market. Suzanne Minter, manager of oil and gas consulting at Bentek in Denver points out: “Over the next five years, daily production in the US is forecast to grow by more than 16bn cubic feet per day, with about 10bcf of that coming from the northeast. Of that, at least 8.5bcf has to be exported. Domestic demand does not grow enough.”

That means a lot of infrastructure like pipelines and storage facilities needs to be built. But that requires regulatory approvals and possibly government intervention. And even then, with US shale gas production projected by the IEA to peak in 2020 and fall slowly over the next decade, this extraction boom is nowhere near as durable as development of conventional oil has proven to be.

But in the stone ages of investing, 18 months was the limits of equity analyst forecasts, and the next quarter seems to be the limits of Mr. Market’s attention. But it is taxpayers that will wind up holding the bag for shale gas infrastructure, particularly if a lot of proves not to be as productive as billed after 2030.

By Nick Cunningham, a Vermont-based writer on energy and environmental issues. You can follow him on Twitter at @nickcunningham1. Originally published at OilPrice

WTI and Brent continued to tumble on Thursday, dropping to their lowest levels since the announcement of the OPEC deal back in November. Brent actually dipped below $49 per barrel, raising fears of another downturn. Both WTI and Brent were off by nearly 4 percent during midday trading on Thursday.

Oil traders have been patient, hoping that despite the rapid rebound in U.S. shale production, the OPEC cuts would take a substantial volume of oil off the market and correct the supply/demand imbalance. But it has been a painful and protracted process.

U.S. crude oil inventories hit a record high of 535 million barrels as recently as the end of March. Several consecutive weeks of drawdowns in April again raised hopes that the market is heading towards balance, but the most recent data release from the EIA on May 3 disappointed yet again, and it was apparently the last straw for some. Market analysts predicted a drop in oil inventories by about 2.3 million barrels, but the EIA said stocks only fell by 930,000 barrels. WTI sank to $46 per barrel and Brent fell into the $40s for the first time in 2017.

Worse, gasoline stocks increased slightly, offering more evidence that motorists are not willing to burn through all the refined products that the downstream sector is producing. Even if refiners suck more crude out of storage, consumers won’t sufficiently burn through all of the additional refined product.

But the most bearish part of the report came from the upstream figures, which once again showed dramatic growth in U.S. oil production. In the last week in April, the industry added another 28,000 bpd, taking U.S. output up to 9.293 million barrels per day (mb/d), up more than 200,000 bpd since the beginning of March, and up more than 450,000 bpd since the start of the year. Output is now the highest since the summer of 2015, and if current trends continue, the industry could break all-time production records before we know it.

U.S. oil production “continues to grow hand over fist, and the market will remain well oversupplied given the lack of” demand for gasoline and diesel, Roberto Friedlander, head of energy trading at Seaport Global Securities, told CNBC.

It is growing more difficult by the day to make the case that oil prices will post strong gains this year. A WSJ survey of 14 investment banks finds an average projected Brent oil prices for this year at $57 per barrel, an estimate that is starting to look a bit overly optimistic.

“Crude inventories fell, because they always do at this time of year,” Stephen Schork, president of Schork Group Inc., told Bloomberg. “This is the 11th straight-weekly gain in production and heading for a modern-day record by the end of the year. I don’t see any way you can spin this as bullish.”

Adding to the supply glut is the fact that Libya has restored large chunks of its production, taking output back above 700,000 bpd. Libya’s National Oil Company is also targeting another 500,000 bpd of gains this year, although that will be easier said than done.

Things are not all bad. On the plus side, hedge funds and other money managers have reduced their bullish bets on crude oil, which is to say, they are not overextended on the upside in the way that they were the last time oil prices fell. That means there is less pent up pressure that could suddenly force prices down further. “We’ve had some pretty sharp price corrections already so it does reduce the risk of length liquidation. I do think as long as OPEC maintains the cuts, the price will get some stability,” Petromatrix analyst Olivier Jakob said to CNBC.

And although it gets lost in the mix, especially when prices start getting volatile, the market is still marching slowly in the right direction. Inventories are declining globally, and many analysts still see more balance later this year.

Moreover, the markets tend to put too much emphasis on one indicator over another. OPEC was given enormous credit in the initial rally up to $50 last November, but some argue that the large OPEC cuts, which are likely to be extended through the end of the year, are now being discounted as everyone shifts their focus to the shale comeback. “U.S. production continues to rise largely in response to supply discipline being shown by OPEC and Russia,” Tim Evans, an energy analyst at Citi Futures Perspective, said in a Bloomberg interview. “It was a mistake during the first part of the year to ignore rising U.S. production and focus exclusively on the OPEC cuts. It’s a mistake now to just focus on U.S. production and assume that guarantees we’ll have an ongoing abundance of supply.”

But the problem with that argument is that to a large degree the OPEC extension has already been priced into the markets. That leaves little upside to an extension but a massive risk to the downside if OPEC fails to extend.

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  1. visitor

    I am baffled by the state of the hydrocarbon industry laid out in this article.

    1) So much shale gas is being extracted that it cannot be absorbed by the US market, and there is no infrastructure to export it either.

    There were plenty of oil&gas operators when the shale boom started who could draw on their experience to figure out some reasonable figures for capex, market growth, need for infrastructure and export possibilities.

    Does the sheer over-investment mean that the industry has been entirely controlled by irrationally exuberant “investors” with no industry competence whatsoever but with so much funds that they do not know what to do with them? Those “18 months forecasters”? While industry veterans remained carefully out of the game?

    2) Stocks of refined products are increasing, as refineries produce more of them to decrease oil stocks.

    From the little I know, crude oil can be stored longer than gasoline or diesel. Why are operators refining oil if there is no demand for the output? If refined products go bad faster, why not just store crude away instead?

    3) The US market is oversupplied with oil.

    Every statistics I came across in the past showed that the USA must import oil, as it cannot produce enough of it (about a half of consumption before the shale boom, a third since). So shale oil should be easily absorbed by the national market.

    Could it be that shale oil is of a quality that can only be used for motor fuel, implying that imports of other oil qualities (for synthetic materials?) remain indispensable, thus leading to an internal oil glut and too much gasoline?

    Scratching my head…

      1. Moneta

        A lot of these players don’t care if it is profitable in the long term. As long as they can raise capital and pad their own personal accounts it makes good business sense to them.

      2. fresno dan

        May 5, 2017 at 7:09 am

        This whole thing reminds me of Charles Prince: “But as long as the music is playing, you’ve got to get up and dance.”

        A cynic might question how wonderful capitalism allocates resources and apparently will shovel money at projects that can only be stopped by financial crisis….but that would be …cynical….


        1. Moneta

          If you want good allocation of money, you’ve got to make sure the speculators know they could lose.

          If you look at these alternative funds, the losers will be the retirees. All the pros in there know they can make their millions, will not go to jail and are betting that government will bail it all out.

          That’s what the credit crisis taught them.

    1. PlutoniumKun

      Shale oil and gas have a number of unique features which can cause all sorts of market issues.

      One issue with shale gas is that it all comes out at once when a well is fracked. A typical conventional gas well that produces X quantity of gas will give that up over 20-25 years (gas operators usually need at least 20 years production to pay back the capital investment), and that output is quite controllable so the operator can respond to market and seasonal issues. A fracked gas well with X capacity will gush its entire capacity within about 18 months. It is possible to cap temporarily, but you just can’t control the output over a longer time period. This is why fracking is only economic when you have a very extensive suitable area of geology (at least 90 sq km), as the assumption is that you will have to keep fracking the area for 20 years or more to justify your investment in hard infrastructure. The combination of a gold rush mentality when an areas geology is proven, with the difficulty of controlling gas production once the gas appears, seems to lead to a boom and bust cycle of production, which is entirely independent of actual demand (exacerbated because you don’t have one single operator controlling output, as you typically would with a conventional gas or oil well, instead you have a multiplicity of small operators, each trying to get as much market share as possible). Some geologists, such as Arthur Berman have argued that gas exploration companies have exaggerated the long term production potential of many of the key shale beds in order to justify their investments. It is, in short, a pets.com situation.

      Shale oil has additional complications. It is ‘tight’ oil – i.e. very light crude (otherwise it won’t flow). The problem is that there is very little refining capacity for such light crudes in the US or elsewhere, so if its brought to a refinery which, like most in the US, is designed for Alaskan or Gulf crude, you have to mix it in with something heavier – typically Venezuelan heavy crude or Canadian crude. So the US can never be oil independent with shale (tight) oil unless the entire refinery infrastructure is rebuilt. Oil is nowhere near as fungible a product as people often assume.

      This is just a taster of the issues, but the core is that a combination of geological and technical realities, refinery bottlenecks, and cheap seemingly endless capital has created a bit of a monster in the US oil and gas industry.

      1. visitor

        Thanks for the information. This basically answers my questions (2) and (3).

        Point (1) seems to be related to an abundance of nearly free money, but I am still wondering why/whether operators with experience in gas/oil extraction plunged into such an unstable segment.

        1. PlutoniumKun

          I suspect (I don’t know this for a fact), but the key issue as to why so many were plunging into an unstable sector is that most investment is not by established oil and gas producers, but mostly exploration companies who’s business model is based on establishing a ‘claim’, and then selling it on (its noticeable how few of the majors invested early in fracking).

          In other words, their profit comes from persuading someone to invest in them, not actually selling oil or gas for a profit. Its a bit like the silicon valley business model of getting rich by persuading investors that your App is the new Facebook, then cashing out before everyone realises you’ve just reinvented a juicer.

        2. Moneta

          Oil & gas producers can’t sit on their reserves waiting for the right oil prices. They need cash flow. When they stop drilling, they implode.

          If you look at resource companies’ books you will see that most of these companies are not profitable over the long-term. When there is a boom, owners and management make a killing with their options and when there is a bust they do major write-offs and set themselves up for the next boom… it’s always the shareholders, the lenders and taxpayers that end up losing.

          Why can this go on? Because oil is the foundation of our economy. Everything is set up to make sure we have cheap oil. So this sector is subsidized in many many ways using capital markets.

          And if the President says the US is going to be energy independent, you know the capital will be flowing into that industry without any allocation analysis.

      2. lyman alpha blob

        Your explanation of the shale gas industry is my understanding as well. To me this whole industry seems ripe for shorting. I’m thinking of the passage in ‘The Big Short’ were one of the players realized that mortgages would reset to higher rates at a fixed date and then at that time the securities would collapse, leading him to take a short position which paid off handsomely. Because these wells only produce for a short period of time, if one could figure out how much untapped capacity is left for any given company or the industry as a whole, it would be similar to knowing the mortgage rate reset date.

        I’ve been pondering this for a few years now, but unfortunately not smart enough to figure out how to make a play nor well-heeled enough to make it worthwhile. Also likely Mr. Market has already priced these facts in, although it didn’t with the CDOs several years ago. If these companies are being kept afloat by irrational exuberance alone it wouldn’t be the first time.

        Maybe Comrade Haygood could just add gas fracking shorts to the Craazyman Fund and I’ll watch from afar ;)

    2. Moneta

      Oil needs to be moved across the US. If you can’t get it to the East, then you need to import, even if you are overproducing. If you won’t let pipelines go through the country, then your oversupply will be looking for new markets in Asia.

      And why would you build multi billion dollar pipelines that affect the environment if that basin peaks in a few years?

        1. Moneta

          I should have invoked nimbyism instead of the environment… but the nimbysts will use it as a pretext.

    3. John k

      Home builders build if when they get loans.

      E&p companies drill and produce if when they get financing, and pay officers big salaries with options so long as the money flows. When the bust comes they lay off all staff, maybe even go bankrupt, then position them selves to obtain defunct leases for when the next wave of financing arrives.
      Lots of projects are apparently justified at low interest rates… investors need to learn why some buy risk free treasuries… problem is so many can’t maintain their standard of living at 3% rates… also explaining equity prices.

  2. The Haff

    Despite many shale oil producers re-emerging from debt restructurings – many still have to produce, even at uneconomic prices to service their debts.

    Costs of production for shale have come down sharply, with many now profitable sub USD 50 per barrel.

    Many commentators underestimated the sheer level of stocks and how long it would take to reduce. Add potential supply disruption reversals in Libya and Nigeria into the mix, plus Shale, and there is an argument to say that production could increase further despite OPEC cuts

  3. Sound of the Suburbs

    The opaque derivatives market, which is about ten times bigger than all the other markets combined, will sometimes blow out into the real world markets.

    Probably what we are seeing here.

    It’s a stupid system, but there you go.

  4. RenoDino

    Three years ago, when oil was over $80 a barrel, I said here that oil prices would crash because of the looming reality of peak oil consumption. Naturally readers questioned my judgement. Since then oil has traded as low as the low $30s and is headed back there again. Every producer now realizes they have maybe five years to get 30 years of reserves out of the ground before prices really crater. The rush for the exit only makes the price fall faster. Enormous amounts of debt and leverage make the situation even more dire. Finally a few big oil companies have come forward to admit that oil is a stranded resource and they see declining demand in the not too distant future. This admission only fuels the panic that investors and producers feel. When oil prices briefly rose above $50 virtually every producer hedged. They knew this was as good as it gets.

      1. RenoDino

        Goldman called the bottom today. Let’s see how many days go by before they reverse that call.
        Right now they are probably selling into the mini rally. I give it three week until they reverse their call after they cover.

        They are playing the short game. The long game is structural.

  5. blert

    The Oil Business used to be ‘wildcatting’ — as there were no end of dry holes// nearly dry holes. [ Or projects so expensive that they didn’t pencil out… like Arctic or deep ocean…]

    FRACKING has totally changed that.

    It’s turned the oil business into the coal business.

    One is no longer hunting for magic hot spots with magically concentrated oil deposits.

    Instead, one is able to exploit extensive horizons — very much like coal seams — that go on forever.

    So Fracking no longer has to deal with ‘dry holes.’

    In a horizon that covers an entire state ( North Dakota) the economic equation is: can I tap the right seam ?

    Can I do it at a decent cost ?

    Can I ship it, the oil, out at a pipeline cost — or do I have to pay a truck & railroad tariff ?

    AOPEC is dead.

  6. rjs

    re this, quoting your 2014 segment:
    So much gas is being developed in the Marcellus and Utica resources of the northeastern US that it really cannot be absorbed by the US market. Suzanne Minter, manager of oil and gas consulting at Bentek in Denver points out: “Over the next five years, daily production in the US is forecast to grow by more than 16bn cubic feet per day, with about 10bcf of that coming from the northeast. Of that, at least 8.5bcf has to be exported. Domestic demand does not grow enough.”

    all that has since reversed…even with US heating demand 17% below normal this year, we took our Ocotober record gas stores down to just average by the end of the winter…EIA projects that the next year wil see a 10% increase in natgas electric generation (replacing coal) while exports ship out 10% of our production…look for a nat gas shortage and a price spike as soon as we see a normal winter…

    1. WobblyTelomeres

      “and a price spike as soon as we see a normal winter…”

      Bwahahaha. Houston, we see a problem.

      1. different clue

        The future may hold ever fewer normal winters going forward, but it may hold some very cold ones now and again.

        The warmists claim to see a connection between the Arctic-Subarctic warming faster than the non-Arctic . . . and the rising instability and prone-ness to random north-to-south-to-north-again wandering of the jet streams. Such a southward-wander was behind the “polar vortex” winters of 3 and 2 years ago. It will happen again “here” and “there”.

        A co-worker from Egypt who still goes back every year or so to visit family has told me that it has snowed a few times lately in Cairo in winter in ways that it never ever used to snow there. And some summer months have been hotter than those months traditionally used to be. This sounds in part like wandering jet stream instability.

        If I understand correctly what the warmists are saying about the jet streams, and if the warmists are correct in their statement of the correlation, then I predict that Cairo will see more memorable snowfalls and maybe even snowstorms every few years than what Cairo used to expect. We shall see.

  7. expat

    Shale is about quality swapping as much as anything else but it still represents a major blow to demand for OPEC oil.
    As much as there is an effort to move away from oil, the economy is still oil-driven. While supply has been too high, demand growth has been weaker than expected. Much of the strength (relative strength) in oil has come from supply disruptions in Libya, Nigeria, Iraq and Iran. Top it all off with large doses of QE and nominal oil prices were supported despite lackluster demand.
    The final nail was our dear old friend Pierre Andurand dumping his positions this week.

  8. ocop

    But in the stone ages of investing, 18 months was the limits of equity analyst forecasts, and the next quarter seems to be the limits of Mr. Market’s attention. But it is taxpayers that will wind up holding the bag for shale gas infrastructure, particularly if a lot of proves not to be as productive as billed after 2030.

    Add ratepayers to that as well. I work somewhat tangentially on the planning side of the electric power industry and the out-right dominance of shale-gas fueled generating sources will–if trends continue–make the cost of keeping the lights on painfully susceptible to future price spikes. Most long-term modeling is showing increasing levels of wind and solar, but really obscene levels of natural gas as it wipes out coal and nuclear.

    While that’s (relatively) good news for power sector GHG emissions (notwithstanding significant un- and/or under-estimated leakage upstream in gas extraction), it means we’re in for a world of hurt when prices inevitably go back up (commodities being mean-reverting-ish on adequately long time-scales…). Ironically this is partly due to the myopia and short-termism engineered into “competitive” deregulated electricity markets.

  9. nonsense factory

    There’s a good book out on the decline of the fossil fuel industry which points to three factors:

    Fossil Fuel Endgame
    Burn Out, by Dieter Helm (2016)

    (1) The end of the commodity super-cycle of the last decade, dominated by the rise of China, and its subsequent return to ‘normal’. Re-normalized, oil prices may fall over the medium and long term.
    (2) The carbon constraint: the climate change issue and its scientific support will eventually force out the fossil fuels.
    (3) The rise of new technologies

    This one specific excerpt on issue #1 is worth reading:

    The belief in the permanency of specific commodity super-cycles is just another manifestation of investor gullibility, company executives, and politicians. The seductive argument that there are ‘special reasons’ why prices can go only one way is not unique to energy. It has been believed by investors in the South Sea Bubble (1720), in Dutch tulips (1800), in the run-up to the Wall Street crash (1929) and most recently in the sub-prime crisis (2007-2008).

    What all these bubbles have in common is the associated belief that the laws of economics can be suspended. Yet the prices of commodities are not exempt. Whilst the prices will not always be the efficient ones (and they rarely are in oil), supply and demand do have to equate – a bit like double-entry bookkeeping. For every seller there has to be a buyer. Someone has to pay – and they must be both willing and able to do so. When the price goes up, demand falls and supply increases. If the price increase is sustained then technological innovation is encouraged. These are the economic facts of life.

    This is precisely what has happened in energy, and why the price of oil halved in late 2014, and then fell even further in 2015. It was a very predictable surprise. These simple bits of economics explain much of what has been going on in energy markets over the last couple of decades – indeed over the last half-century – and yet they pass most politicians, and company executives, by. A cursory look back at oil price predictions in the run-up to the 2014 collapse is sobering. Goldman Sachs expected $200 per barrel. The major companies all publish economic outlooks, and these too make embarrassing reading. The key point is that their chief executives believed them, and they backed up these forecasts with billions of dollars of investments, which depended on high prices, from the tar sands in Alberta to drilling in the Arctic.

    1. Jim Haygood

      One has to wonder whether Dieter Helm is holding his chart upside down when he rabbits on about “commodity super-cycles.” This chart ending in 2012 shows the inflation-adjusted CRB commodity index:


      From 2013 through now, the CRB shed another third of its value, placing it near the epic 2001 low, which in turn was the lowest level of commodities since the Great Depression bottom in 1933.

      Commodities have been beat up so savagely, for so long, that they really have nowhere to go but up. Over the past decade, central banks have expanded their balance sheets by a factor of five or so. But real commodity prices have actually fallen. What is wrong with this picture?

  10. vegeholic

    Investors count barrels of oil and billions of cubic feet of gas but nature counts surplus energy. When the surplus energy declines, its ability to produce prosperity declines. Then there are all of the “externalities”. Fracking requires massive amounts of water, and converts whole landscapes into sacrifice zones. Are you and your family eager to drink the groundwater in a region being heavily fracked? I am guessing the answer is no. There appear to be no costs to the owners and investors involved in this destruction of livable habitat. But just because the true balance of costs and benefits is being obscured, does not mean it is not being strictly accounted for somewhere.

  11. TiPs

    What underlies the current problems in the market is that the futures markets (and prices) are dominated by financial traders. Open interest (measured by short positions) from the most recent COT report shows commercial traders with < 30% of the market. After OPEC announced its agreement in December, speculative long bets increased until hitting a record high near the end of February. These financial bets pushed the price of wti above $50, which allows shale producers to lock in prices for the next year. Meanwhile, with prices divorced from fundamentals, inventories continued to accumulate. It was simply a matter of time…

    A related issue is that the big players in the market all had an incentive to maintain the higher prices. OPEC and Russia, Wall Street banks (last year they were holding over $80 billion in energy loans), and the Hedge Fund long bets, some of which were funded by the banks. Over the past two months, the banks and OPEC were preaching "patience" to the Hedgies, but you can't herd the rats when the ship is sinking.

    If markets worked–if commercial interests dominated price discovery, then the price of crude would've remained near $30 for a longer time last year, creating a serious market shake out, which of course would've caused problems for the banks and the various budgets of OPEC countries. Because of this, I also believe that the banks and OPEC will not let the price (wti) fall below $40, which means oil prices will be stuck in the $40-$60 range for quite some time. There is also the matter of Saudi Aramco's IPO in 2018 and a higher oil price will certainly help its valuation…

  12. Quantum Future

    Hey, what happened to all the articles in 2007 that said we are running out of oil and are all going to die?

    1. different clue

      Were there any articles which said we were all going to die from running out of oil?

      1. Dave

        Yes, there was quite a bit of hysteria related to peak oil and how civilization would collapse. There were even a couple of TV specials on it. I remember visiting peak oil websites and there was a white hot panic over the coming oil apocalypse as they discussed the best survival strategies from bug out bags to off the grid living, food production and self defense.

    2. Moneta

      We are all going to die.

      And it is possible to produce 10 years worth of oil in 1 even if reserves are limited.

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