‘Brutal’ Year Anticipated in the Oil Sector

By now it would seem that everybody on the planet is aware that there has been a collapse of epic proportion in the oil world. A number of factors, however, make this story compelling, and the most important of these is the fact this was so unexpected and unpredictable. Although there is nothing new about oil gluts or the volatility of this market, the past year or so is unprecedented in its extent and severity. It seems that none of the usual rules are being followed and that creates consternation as far as what happens from here. It doesn’t seem logical at first blush, but those who take the long view are really concerned that oil prices could hit all-time highs in the not-all-that-distant future—maybe as high as $200 a barrel if the whole scenario plays out as feared.

The first issue to consider is why reaction to the current glut has been so different. In the previous situations, producers took familiar steps to get prices back up. They cut production. In the last 30 to 40 years, the reduction in output was essentially managed by the OPEC cartel—this was the main reason the cartel was formed in the first place. Major oil states agreed to act in a unified manner to manage the supply and price of oil. As OPEC lost control over the oil world, there was considerably less interest in cooperation and it became every country or producer for themselves. Even without a cartel calling the shots, it would seem logical for producers to reduce output when demand slumps, but there has been a significant change in the way that oil is developed.

The big changes in the oil world have been driven by technology over the last few years and that has changed the strategies of the producer. There is a great deal of investment in oil now, and that makes producers reluctant to halt production even as prices fall—they need the cash flow even if it is significantly reduced. The other change of note is that oil extraction is harder than it once was. Twenty or 30 years ago, an oil producer could essentially turn the spigot on and off. If one wanted to reduce output, it was a pretty simple task, and when the demand went back up, the ramp up was swift. That is no longer the case, as shutting down operations can be costly and getting things back can be even more expensive. Many producers are electing to keep on developing as it is cheaper to sell at a low price now than to try to get back to normal production levels later.

This is the essence of the long-term concern. Producers are going to face a wall sooner than later. They have already elected to halt almost all new drilling and even exploration. There is far too little profit to be made to justify any additional capacity. The next step will be to shutter current production in an attempt to dry up supply. Unfortunately, these closures will not be strategic or organized—this will be businesses and operations failing and leaving the market altogether. If this happens enough, there will soon be too few producers to handle future demand. The situation will reverse and in a hurry. The demand will not be met, and suppliers will not be able to rush back into business and the glut suddenly reverses and becomes a major shortage—hence the fear of $200 a barrel oil.

- Chris Kuehl, Ph.D., NACM economist and co-founder of Armada Corporate Intelligence 

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