Why Oil Could Drop to $40 a Barrel

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Source: Thinkstock
The six-month production cuts announced by the Organization of the Petroleum Exporting Countries (OPEC) and its non-OPEC partners boosted the price of crude oil by about $10 a barrel to around $55. The cartel is meeting later this month to discuss extending the cuts for another six months, but an extension may not do the trick.

OPEC’s goal is to raise the price to around $60 a barrel, or even $65 if truth be told. That no longer seem possible unless the cartel and its partners agree to even steeper cuts. Such a scenario is hard to imagine.

The producing nations have been amazingly committed to the lower quotas, but even so, global stockpiles simply refuse to be drawn down. Partly that’s the result of more U.S. production and partly it’s the result of lower demand.

Last Friday, analysts at Goldman Sachs said in a note reported by MarketWatch:

Net, the faster decline in long-term oil prices than we expected this year is a clear downside risk to our spot price level forecast, even if it helps slow US production growth and achieve the inventory draws and the rotation of the forward curve into backwardation that we have forecast.

Backwardation is the commodity market condition where current spot prices are higher than forward prices. As futures contracts decline, more oil is likely to become available on the spot market, keeping a firm lid on current prices.

According to energy industry consultancy Wood Mackenzie, the average North American shale play’s breakeven price is now below $50 a barrel, with break-even prices in some fields (the Wolfcamp formation in the Permian Basin, for example) below $30 a barrel.

In addition to lower production costs, most U.S. producers hedged a significant portion of 2017 production following the OPEC announcement of production cuts. RBN Energy reported Monday on a new report from Bloomberg Intelligence on the push that U.S. producers made into new hedges when crude prices approached $55 a barrel last December:

[T]he median percentage of 2017 oil production hedged by 37 significant U.S. oil producers examined in the Bloomberg report soared from 31.7% at the end of the third quarter of 2016 to 46.8% at year-end 2016… . Thirty-two of the 37 E&Ps had 2017 hedges in place as this year started, with 15 of those protecting more than half of their projected output and 29 companies protecting at least one-quarter of production.

RBN goes on to note that a dozen companies drilling in the Permian Basin have protected 64% of their 2017 output.

Companies that have protected their pricing have little incentive to lower 2017 production. 2018 output is currently less well protected with hedges. Bloomberg reported that just 21 of the 37 companies it reviewed had any 2018 hedges in place and among those 21, less than 10% of expected production is hedged.

Adding to OPEC’s difficulties, U.S. crude oil exports have doubled since last year, reaching a four-week average of 736,000 barrels a day last week. Refined product exports are averaging about 4.8 million barrels a day this year, a third higher than a year ago. U.S. exports cannot make up for all the production cuts, but they can ease the pressure for rising prices.

On last point. U.S. rig counts have been rising for months, and so has production. It may take as long as six months for new rigs to begin producing, so even if rig counts fail to increase as fast as they have been, there remains plenty of potential production out there to come onto the market.

The limited effectiveness of the OPEC-led production cuts in reducing global inventories, combined with higher North American rig counts, lower U.S. production costs, and extensive hedging of U.S. 2017 production could continue to weigh on prices. Unless demand picks up, $40 oil is a real possibility by the fall.