(Note: this is a condensed and updated version of a Special Bulletin published on December 18, 2015)
Producers, consumers, and investors have witnessed a stunning 70% drop in the price of oil over the last 18 months. This has resulted in huge declines in employment in the energy and mining industries, and lower gasoline prices for consumers. It has also led to a significant increase in economic pressure among those countries heavily dependent on oil revenues for government spending.
In every free market, price is dictated by supply and demand. In 2015, demand growth was strong, but not as strong as one would expect given the freefall in prices. Over half of the annual growth in demand for oil in the latter part of the last decade came from China. As a result, China’s much-publicized economic slowdown clearly has had a negative impact on overall demand.
The rise of shale oil production over the past decade in the United States has greatly diminished OPEC’s ability to set prices in the marketplace. Despite falling prices, OPEC has maintained production levels in order to force higher-cost producers out of the market. So far, this strategy has largely failed, as production has remained relatively stable.
Congress recently passed a $1.1 trillion spending measure that provides tax credits for the use of alternative energy sources (e.g., solar, wind) and lifts the 40-year-old oil export ban. In the long run, increased use of renewable energy sources could crimp demand for fossil fuels, but in the near term, it should result in an increase in domestic oil production. North America’s growing production capacity has diminished OPEC’s price-setting ability on global oil markets, and this trend is likely to continue as domestic production increases.
The decline in oil prices has resulted in massive global rig reductions, most notably in the U.S. and Canada. International rig count is down only 16%, primarily because of larger/longer projects and because national governments need oil revenues to balance their budgets. Despite the sharp reduction in rig count, U.S. crude oil production is still high. Producers have become increasingly efficient by using newer drilling techniques and focusing on core acreage areas. They are pumping more from fewer rigs.
With large debt burdens that require servicing, oil exploration companies have chosen to keep the taps flowing in order to generate revenue. Shutting down rigs and cutting jobs has allowed them to lower their breakeven prices, but most U.S. shale oil producers are losing money at the current price of oil ($31.41 per barrel as of January 11, 2016). The excess supply is rapidly filling the capacity of storage facilities. This is an unsustainable situation, and production is beginning to decline as smaller producers exit the business.
We believe that overall weak global demand and limited excess capacity will constrain production in the near term, helping to keep a floor under prices. On the other hand, the imminent introduction of Iranian oil onto global markets and the ability of U.S. producers to restart production at the first sign of higher prices is likely to prevent oil from rising much above the $50 to $55 per barrel for the foreseeable future.
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