Simple And Indisputable Facts About Oil

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Includes: OIL, USO
by: Asterisk Capital

Summary

Supply and demand will be balanced by American producers.

OPEC will not cut to boost prices.

Prices should recover modestly in the second half of the year.

Overview:

It is known that eventually the world will not depend on fossil fuels or power generation and fuel for transportation. However, that reality is decades away and should not shutter the fact that America and all nations are and will be dependent on crude oil for the foreseeable future. Therefore, it is a worthwhile exercise to analyze the price of various grades of crude (NYSEARCA:USO), who produces the crude, and who holds power to the price of crude.

Major Players:

OPEC (Organization of Oil Exporting Countries) is the largest collective holder of oil reserves in the world. To give an overview of which OPEC countries have the largest reserves in the most recent data available see the chart below. Venezuela holds the largest reserves of any OPEC member with Saudi Arabia not far behind. While the production longevity of a nation is dependent on the size of the reserves, the important number to determine is the breakeven price for the major OPEC countries. While the breakeven is important to know for smaller OPEC countries such as Angola and Ecuador, the power they exert is minimal. The Islamic Republic of Iran has for years been an irrelevant member of OPEC due to the Western sanctions that crippled its oil production capabilities. In the next few months, Iran will return to exporting oil and is a threat to currently depressed price.

Click to enlarge

Source: OPEC

Saudi Arabia has been coined the "swing producer" for the past few decades and is the decision maker within OPEC. Therefore, OPEC will implement policies that are more aligned with the interests of Saudi Arabia rather than those of less important member nations. The Saudi's have substantial foreign reserves of approximately $635 billion, according to the International Monetary Fund. The foreign reserves can be used to weather the storm, but at what point does it become irrational to deplete reserves rather than cut supply? That point may appear sooner than most think. Saudi Arabia has resorted to cutting subsidies on gasoline in the Kingdom and will be forced to pursue further subsidy cuts if the price of oil does not start to rise. The use of subsidies have been used by the Kingdom to keep the populous happy and was able to escape mostly unscathed from the Arab Spring. If the subsidies were cut substantially, the population could turn on the government and unrest could follow.

Major OPEC Fiscal Breakeven Points:

The chart below has the fiscal breakeven points for Saudi Arabia, Iraq, Iran, Kuwait, and the UAE, according to the International Monetary Fund. The fiscal breakeven average for the five major Middle East OPEC members is edging up from the projection for 2015 to the 2016 projection due to the increase in the fiscal breakeven for Iran. Essentially, member nations can issue debt or use monetary reserves to wait out the low oil environment, but these prices are not sustainable.

Country

2014

2015 Projected

2016 Projected

Saudi Arabia

102.3

87.2

86

Iraq

104.6

68.1

68.8

Iran

95.1

107.4

119.4

Kuwait

57.4

49.4

49.2

UAE

74

73.8

69.5

Average

86.68

77.18

78.58

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Supply Demand:

The excess of supply compared with demand has led to West Texas Intermediate and Brent Crude prices reaching lows not seen since the early 2000's. According to the International Energy Agency, supply and demand should continue the course to reaching an equilibrium. Iranian oil could cause the supply to remain bloated. Although, it should not be forgotten how much investment in oil infrastructure will be needed in Iran after being subject to Western sanctions. At this time, the Iran threat to oil supply is a concern that will have a minimal impact. Additionally, Iran has stated they have no intention to flood the market with crude that could lead to additional price decline.

Source: IEA

Return of the American Producer:

Beginning in 2008, the American oil producers being to produce at an accelerated rate that started to catch up to Saudi Arabia. According to EIA data, between 2012 and 2013, America began to produce more oil than their Saudi Arabia counterparts. Fast forward to 2014, the United States has become a serious contender in global oil production. Saudi Arabia has the strategy of punishing the American producer that started producing at higher cost and want to squeeze them out. In the graph below, it displays how the production from the United States has become an ever increasing component of global oil production.

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Source: EIA

Result:

The American producer has proved to be more resilient than originally thought. Shale producers have shut down rigs and implemented technology to lower the breakeven price. The shale producers will continue to operate at these low price environments if they can breakeven. Shale producers have a breakeven ranging from $42-$80. The producers in the $55-80 range are most likely shut down or will be very soon, while the producers on the lower than $50 are going to survive the longest.

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Source: Rystad Energy

Outcomes:

  1. OPEC decides to cut supply and the price of oil rebounds.

Issue: Shale producers have capped wells and have wells that can be brought online quickly which may fill the supply cut made by OPEC.

Probability: Very Low

  1. American production will be severely reduced to rebalance supply and demand.

Issue: This will be a slow process and will time.

Probability: Medium-high

The increase in oil prices should occur towards the second half of the year and will remain highly volatile till then. It is highly unlikely that the prices of crude will reach $10 per barrel as estimated.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.