After A Bloodbath In Oil, What Next?

Christopher Helman

Welcome back from Thanksgiving week. Apparently OPEC did something and oil prices plunged. If you were as out of touch with it all as I was last week, here’s a rundown.

As we tucked into Turkey and football last Thursday, OPEC announced no output cut, no target price and no output ceiling. Sounds like a lot of no news, but the OPEC meeting has been described in historic terms. Bloomberg’s headline declared that war had broken out: “Oil enters new era as OPEC faces off against shale; who blinks as price slides toward $70?” The accompanying article made the case that OPEC is indubitably locked in a price war against U.S. shale producers.

Oil prices plunged on the OPEC news. West Texas Intermediate crude is now at $65 a barrel. It was $107 back in June.

That Bloomberg article had my favorite quote of the week, from Leonid Fedun, a board member at Russia’s Lukoil. Fedun said that by maintaining output levels, OPEC would bring about an outright crash among U.S. shale drillers. “In 2016, when OPEC completes this objective of cleaning up the American marginal market, the oil price will start growing again,” said Fedun. “The shale boom is on a par with the dot-com boom. The strong players will remain, the weak ones will vanish.”

No surprise, Friday was a bloodbath for shares of America’s oil and gas independents.

Goodrich Petroleum GDP -34.24% fell 34% on the day, and is off 79% in three months. Swift Energy fell 30%, Penn Virginia and Sanchez Energy SN -29.48% down 29%, SandRidge 26%. Some of these, like Swift, are highly leveraged, and there’s even some concern that bidding could dry up for the junk bonds issued in recent years to finance the U.S. oil boom — enough to cause a sudden credit crisis.

There’s plenty of stronger producers, like Devon Energy DVN -7.89%, Noble Energy NBL -8.64% and Pioneer Natural Resources PXD -10.93% have hedged a large portion of their oil production at higher prices. Drillers with land in the sweet spots of shale plays will survive the low price drubbing and may even keep growing output. And even after recent share losses, many frackers trade at solid valuations. Shares in Harold Hamm’s Continental Resources CLR -19.91% are still worth six times what they were at the nadir of the last oil price plunge in 2009.

Argus Media quoted the Iranian oil minister as saying that squeezing non-Opec production out of the market will take years rather than months.

Indeed there’s a real question as to how much pain OPEC nations and other exporters will be willing and able to endure at the hands of the Saudis. Oil journalist Derek Brower tweeted from Vienna last week that there was lots of anger at the OPEC meetings, with Algerian and Venezuelan oil ministers “furious” that the Saudis refused to cut output. An Iranian oil ministry source told Brower that Iran thinks the Saudis are trying to ruin both it and Russia.

Iran, of course, has been hobbled by sanctions, while Venezuela’s kleptocrats clearly need higher prices in order to delay the inevitable bankruptcy and collapse of their regime. There’s even evidence (reported by Bloomberg last week) that Venezuelan officials have ordered its U.S. refining and marketing operation Citgo to sell assets in secret and repatriate dollars to Venezuela.

Venezuela’s currency, the bolivar, plunged on Friday. According to Prof. Steve Hanke of Johns Hopkins University, the black market value of the bolivar has fallen from 19 to the dollar in January 2013 to 150 to the dollar last week. Hanke also notes that implied inflation in Venezuela is running at 150% a year. As bad as the shale drillers might have it, Venezuela’s got it worse.

Russia would prefer a Saudi cut too. The Moscow Times had a nice overview, reporting that cheap oil threatens Russia with recession and budget deficits and quoted Vladimir Putin as saying that if oil prices stayed below $80 for a significant length of time it would bring world economic collapse. That’s incredibly unlikely, of course. Cheaper energy, on the whole, will be supportive of economic growth and development. Just not in petrostates like Russia. On Friday the rouble fell to a record low of 50 to the dollar.

No wonder Putin’s oil champion Rosneft looks troubled; low prices will make it much tougher to service the $60 billion in debt it piled up acquiring TNK-BP last year. Rosneft shares are down nearly 40% this year.

So where’s the price of oil going and why? Who the hell knows? The global trade in oil accounts for half the value of all the world’s traded commodities and sets pricing for much of the rest. If you think you know the secret algorithm that governs that trade, you’re crazy. As Ben Hunt, chief risk officer at Salient Partners in Houston, wrote in his most recent report, “The Unbearable Over Determination of Oil,” if you add up all the myriad explanations for oil prices you can explain away the entire price move several times over. Every explanation contributes to pricing, but none contributes as much as their proponents believe.

It’s time, says Hunt, for anyone in the oil business or investing in the oil business, to understand that the market right now is “ structurally unstable” and that regardless of how and why you place your bets you need to be ready to be whipsawed and wrong.

With that in mind, here’s a few things I’m thinking about:

First of all, it’s not all about OPEC. Sure, what the Saudis decide to do has an impact on the oil markets. But remember that they decided to do nothing. No increase or decrease in production or quotas, just maintain the status quo, maintain market share.

Second, oil supplies will contract on their own. Low prices cure low prices. Drilling in the marginal shale plays will stall out. Some Canadian oil sands projects will be canceled. Cash strapped petro regimes will not reinvest scarce dollars in new drilling. Thus, in time supplies will tighten up again.

Third, cheaper oil is good for economic growth. Energy is an economic input; it’s not the economy itself, unless you’re Russia.

Fourth, don’t underestimate the impact of currency exchange rates. Venezuela, Nigeria, Angola, Russia and other exporters might be getting fewer dollars for their oil, but because their currencies have been weakening so much against the dollar, in local terms their budgets aren’t as out of whack as all the “fiscal breakeven” numbers suggest.

Fifth, over the long term the price of oil will be governed by the marginal cost of production. If demand is soft or declining, prices can remain low for some time. But as soon as the excess is worn off, the price floor will have to be high enough to incentivize the production of that last barrel needed to meet demand.

Sixth, who says $66 a barrel is cheap? The inflation-adjusted average oil price over the past three decades is closer to $40 a barrel. Reversion to the mean wouldn’t be pretty.

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