It is possible that a miracle intervenes and that the price of oil bounces
off and zooms skyward. But miracles have become rare. US light sweet crude
last traded at $76.90 a barrel, down 26% from June, a price last seen in the
summer of 2010.
But this price isn’t what drillers get paid at the wellhead. Grades of oil
vary. In the Bakken, the shale-oil paradise in North Dakota, wellhead prices
are significantly lower not only because the Bakken blend isn’t as valuable
to refiners as the benchmark West Texas Intermediate, but also because
take-away capacity by pipeline is limited. Crude-by-rail has become the
dominant – but more costly – way to get the oil from the Northern Rockies to
refineries on the Gulf Coast or the East Coast.
These additional transportation costs come out of the wellhead price. So
for a particular well, a driller might get less than $60/bbl – and not the
$76.90/bbl that WTI traded for at the New York Mercantile Exchange.
Fracking is expensive, capital intensive, and characterized by steep decline
rates. Much of the production occurs over the first two years – and much of
the cash flow. If prices are low during those two years, the well might never
be profitable.
Meanwhile, North Sea Brent has dropped to $79.85 a barrel, last seen in
September 2010.
So the US Energy Information Administration, in its monthly short-term energy
outlook a week ago, chopped down its forecast of the average price in
2015: WTI from $94.58/bbl to $77.55/bbl and Brent from $101.67/bbl to
$83.24/bbl.
Independent exploration and production companies have gotten mauled. For
example, Goodrich Petroleum plunged 71% and Comstock Resources 58% from their
52-week highs in June while Rex Energy plunged 65% and Stone Energy 54% from
their highs in April.
Integrated oil majors have fared better, so far. Exxon Mobil is down
“only” 9% from its July high. On a broader scale, the SPDR S&P Oil &
Gas Exploration & Production ETF (XOP) is down 28% from June – even as
the S&P 500 set a new record.
So how low can oil drop, and how long can this go on?
The theory is being propagated that the price won’t drop much below the
breakeven point in higher-cost areas, such as the tar sands in Canada or the
Bakken in the US. At that price, rather than lose money, drillers would stop
fracking and tar-sands operators would shut down their tar pits. And soon,
supplies would tighten up, inventories would be drawn down, and prices would
jump.
But that’s not what happened in natural gas. US drillers didn’t stop
fracking when the price of natural gas plunged below the cost of production
and kept plunging for years until in April 2012 it reached not a four-year
low but a decade-low of about $1.90 per million Btu at the Henry
hub. At the time, shorts were vociferously proclaiming that gas storage would
be full by fall, that the remaining gas would have to be flared, and that the
price would then drop to zero.
But drillers were still drilling, and production continues to
rise to this day, though the low price also caused an uptick in consumption
that coincided with a harsh winter, leaving storage levels below the
five-year minimum for this time of the year.
The gas glut has disappeared. The price at the Henry hub has since more
than doubled, but it remains below breakeven for many wells. And when natural
gas was selling for $4/MMBtu at the Henry hub, it was selling for $2/MMBtu at
the Appalachian hubs, where the wondrous production from the Marcellus shale
comes to market. No one can make money at that price.
And they’re still drilling in the Marcellus.
Natural gas drillers had a cover: a well that also produced a lot of oil
and natural gas liquids was profitable because they fetched a much higher
price. But this too has been obviated by events: on top of the rout in oil,
the inevitable glut in natural gas liquids has caused their prices to swoon
too (chart).
Yet, they’re still drilling, and production is still rising. And
they will continue to drill as long as they can get the moolah to do so. They
might pick and choose where they drill, and they might back off a smidgen,
but as long as they get the money, they’ll drill.
Money has been flowing into the oil and gas business in form of a tsunami
unleashed by yield-desperate investors who, driven to near insanity by the
Fed’s scorched-earth policies, do what the Fed has been telling them to do:
close their eyes and hold their noses and disregard risk and hand over their
money, and borrow money for nearly free and hand over that money too.
Oil and gas companies have issued record amounts of junk bonds. They’ve
raised record amounts of money via a record number of IPOs. They’ve raised
money by spinning off assets into publically traded MLPs. They’ve borrowed
from banks that then packaged these loans into securities that were then
sold. The industry has been awash in cheap money and has drilled it into the
ground.
This is one of the consequences of the Fed’s decision to flood the land
with free liquidity. When the cost of capital is near zero, and when returns
on low-risk investments are near zero as well, or even below zero, investors
go into a sort of coma. But when they come out of it and realize that “sunk
capital” has taken on a literal meaning, they’ll shut off the spigot. Only
then will drilling and production decline. As with natural gas, it can take
years, and the price might plunge through a four-year low and hit a
decade low – which would be near $40/bbl, a price last seen in 2009. The
bloodletting would be epic.
Worldwide, the balance of power in the oil business is shifting. Read… Oil
Price Collapse Ricochets Around the World, Hits US Drillers, the Ruble … and
Russia’s Probability of Default
