Crude Oil - How Low Can It Go?

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Dartmouth Business Journal

The last few months have not been easy on the price of crude oil. Since May 2015, Brent Crude, the global benchmark for crude oil value, has fallen over 60 percent, reaching a decade low of $28.55 a barrel on Jan. 18, 2016. The price of crude oil continues to break record lows, with the global oil market losing a fifth of its value since the start of the new year. Oil's precipitous drop is attributable to a massive supply glut that results from a variety of factors, ranging from innovative drilling techniques to geopolitical conflicts.

The shale oil revolution

U.S. oil production has steadily expanded in the past five years, with average daily crude oil production rising from 5.5 million barrels a day in 2010 to 12.7 million daily barrels in October 2015 according to the Energy Information Administration (EIA).

The increase in U.S. oil production is fueled by the rapidly growing shale oil industry. Shale oil extraction targets light crude oil stored in petroleum-bearing rock formations of shale or sandstone. Production of oil from the rock formations requires hydraulic fracturing, a technique in which rocks are subjected to highly pressurized liquids that break the formation and expose petroleum reserves within. The U.S. possesses multiple shale assets that contain valuable petroleum-bearing rock formations, such as the Eagle Ford Group in Texas and the Bakken Formation spread between Montana and North Dakota.

As a result, crude oil production in the U.S has become both cheaper and more prolific in the past decade, becoming a major contributor to the steady increase in global daily crude oil supply from 88 million barrels in 2010 to 93 million in 2014 as reported by the EIA.

Market war between OPEC and US shale suppliers

The Organization of Petroleum Exporting Countries (OPEC) is an intergovernmental organization that controls over 80 percent of the world's oil reserves, a position that gives the cartel an immense amount of control over the global supply of oil. In 1973, Arab OPEC member states declared an oil embargo against the United States and other nations that supported Israel during the Yom Kippur War. The embargo, lasting from October 1973 to March 1974, caused a jump in the per barrel price of $9, from $3 per barrel to $12. It also sparked a global recession, signaling the end of the post-World War II period of economic prosperity.

In the past decade, however, the growth of the shale oil industry in the United States has presented a significant threat to OPEC's oil dominance. At OPEC's semi-annual meeting in December 2015, the organization decided to raise its daily production quota from 30 million barrels to 31.5 million barrels, a sign that the oil-exporting countries are unwilling to give up market share to U.S. shale producers so easily. OPEC intends on squeezing non-OPEC supply out of the global oil market by dropping the price of oil to unsustainable levels for non-OPEC suppliers.

The effects of OPEC's bid for dominance are still being felt in the United States. Take for example ConocoPhillips (NYSE:COP), the world's largest pure energy exploration and production company and operator of multiple drilling assets in Eagle Ford and Bakken Shale. The company's equity lost over 35 percent of its value since June 2015 according to Yahoo Finance, with further losses expected on the horizon. Chesapeake Energy (NYSE:CHK), the second largest oil and gas producer in the United States, faced similar losses, with its share price falling 70 percent since June 2015 as reported by Yahoo Finance. Multiple smaller shale oil companies have already gone bankrupt, with Samson Resources Corporation filing for Chapter 11 bankruptcy in September 2015 and Escalera Resources (NASDAQ:ESCR) more recently following suit in November 2015.

What does the future hold for crude oil?

On Jan. 8, 2016, the EIA declared that the amount of crude oil commercially stored had reached 482.6 million barrels, a number just under the 80-year high in terms of crude oil storage. Furthermore, global oil storage is projected to increase throughout 2016. The International Energy Agency announced in its Oil Market Report for December 2015 that it expects a steady increase in production and inventory storage throughout 2016:

Global inventories are set to keep building at least until late 2016…[OPEC]the exporter group has effectively been exporting at will since Saudi Arabia convinced fellow members a year ago to refrain from supply cuts and defend market share against a relentless rise in non-OPEC supply."

With storage of oil reaching near record levels, a sharp increase in oil demand will likely have a delayed impact on the price of oil as supply is slowly drained from global inventory.

The lifting of Iranian sanctions in January 2016 presents another troubling prospect for the future of crude oil. Iran is a major exporter of crude oil that experienced a fall in production of more than one million barrels daily after international sanctions were enacted in 2012. With the world's fourth largest oil reserves, Iran's re-entry into the global market will further increase an already bloated glut of supply. Iranian officials stated that the country was in the process of increasing production by 500,000 barrels a day, with the ambition of expanding Iranian production capacity to six million barrels daily.

On the demand side, things look more hopeful. World oil demand is projected by the International Energy Agency to increase steadily through the end of 2016, with daily demand increasing from 94.69 million barrels in Q1 2016 to 96.49 million barrels in Q4 2016.

We must wonder, however, if demand will be able to outpace consistently increasing supply throughout 2016. Even if the global oil market experiences a supply shock on the magnitude of Saudi Arabia ceasing to produce oil, the impact of the shock will arrive late into 2016 as stockpiles of crude slowly recede from current record levels. As a commodity, crude oil is naturally subject to the market forces of supply and demand, and those market forces see crude oil losing value through the end of the new year.