Dark Rumblings in Oil Economics

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Oil prices have stayed low for some time now, but there are dark rumblings concerning the future of crude oil. Rig counts are dropping, the domestic shale boom has busted the wallets of oil producers, turmoil in Middle East is increasingly threatening oil supplies, and the Organization of the Petroleum Exporting Countries (OPEC) may be running low on its capacity to buffer strategic reserves. The confluence of these events could spell disaster for the American economy and another 1970’s size oil shock.

First and foremost, there are serious problems with domestic oil production. Oil production in the U.S. has gone up significantly thanks to shale fields, like the Bakken and Permian, but that production may already be past its prime. The first danger to domestic production is profitability.  For some time now domestic gas companies have been operating at a substantial loss. In July the Energy Investment Administration (EIA) reported reported that domestic oil producers operated at a net $110 billion loss. It’s been fairly easy for oil and gas companies to secure investors thanks to the proliferation of the investment sector and low interest rates, but neither of those systemic factors can compensate for the damage that low oil prices are having on domestic producers. The truth is that even higher oil prices may not be able to save the fracking industry.

Much of the cost incurred by the oil industry is up front money. New rigs cost big bucks, but maintaining a site is comparatively cheap. This is good news for more traditional methods of oil extraction where sites can operate at or near peak capacity for long periods of time, but this dynamic is ugly for shale. Bloomberg reports that, “The average flow from a shale gas well drops by about 50 percent to 75 percent in the first year, and up to 78 percent for oil,” which means that the long haul strategy that has made other oil producers so wealthy simply won’t work for the fracking industry. The industry itself has been operating at a net loss since 2010 and the difference between costs and profits has only widened because of the quick rate of depletion. The only way for domestic companies to recoup their costs is to produce and sell more oil, but that only exacerbates the price problem.

The next domino in the oil chain is the net availability of oil. The EIA has no good news and shows that rig counts and total oil production have both recently declined. This decline is happening despite the fact that spending by oil producers has remained at nearly $700 billion since 2010. Investment has stagnated, and apparently 700 billion isn’t buying as much oil as it used to. Leonard Brecken, a hedge fund manager and regular contributor at Oil Price, speculates that at current price points U.S. oil production may have reached its peak and adds that “Shale is becoming the .COM bubble of the 21st century.” It’s possible that the only thing that could save domestic oil is a tremendous price spike, and that may be on the horizon.

Much of the sustained low price oil can be attributed to the Saudis increasing production. A Reuters contributor explains, “The Saudis have basically declared war on the U.S. oil producers.” The Saudi’s capacity to wage price war may be running out though. An article in Time cited a PIRA report saying “Incremental Saudi crude burn demand could push its volume this summer to levels that would substantially reduce global spare capacity, at a time when oil markets will be tighter and geopolitical risks to supply are growing” This means that the buffer keeping oil prices low may be disappearing. The combination of a potentially limited Saudi output and the possibility of disaster in the Middle East caused by ISIS may create ballooning oil prices.

Right now the oil industry is stuck between a rock and a hard place. If oil prices stay low, and those low prices keep demand high, then domestic oil producers are going to keep operating at a loss. If instability or dwindling Saudi oil reserves sends prices upward, domestic oil producers may become profitable again, but high prices could kill demand.