The Case for $20 Oil

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Oil prices have dropped to $35 a barrel, down from over $110 in 2011. The trend line does not mean much; it is just a chart. But that does not mean the causes of the trend are not obvious, and likely are also not over.

The argument for lower oil prices breaks into a very few parts. The first is that massive oil producer Saudi Arabia means to destroy the industry financially so that it can keep its long-term leverage on pricing. Its production costs are low enough that its strategy might work. But even Saudi Arabia cannot pump cheap oil forever without affecting the kingdom’s treasury, and perhaps crippling it for decades.

Another cause is fracking, an industry that bet high oil prices would last for years or even decades. It is an expensive business to get into, with somewhat new age technology, so frackers need prices well above the current ones to remain is business. Supply is ample. Funding is not. Bankruptcies are not only possible, but they already have begun. Analysts from Bloomberg recently wrote:

According to the consultancy Wood Mackenzie, about a third of oil production in the U.S. states, not including Alaska and Hawaii, comes from companies that have borrowed against their oil and gas reserves and that face redeterminations of their borrowing base. Banks recalculate the value of reserves for their oil company clients twice a year, in the spring and in the fall. Forecasts for the October redeterminations are dire. Last month, a survey conducted by the law firm Haynes and Boone predicted a 39 percent decrease in the oil companies’ borrowing ability, with 79 percent of borrowers expecting a decrease.

For financiers, better to take a beating now than a worse one later.

Finally, there is the theory that China’s economy has slowed. As the world’s largest importer of oil, it makes sense that the demand loss would take a bite out of the price of crude. On the other hand, the economies of the United States and Europe are recovering. The analysis has become a tightrope of expert forecasts.

Is past performance an indication of future results? No, as mutual funds would say. However, for oil prices that answer may be different.