$40 Per Barrel May Be The New $100 For Oil - Why That's Fine For Some Competitors

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Includes: BNO, DBO, DIG, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Gary Bourgeault

Summary

Who has been quickly preparing for a prolonged period of lower oil prices.

Clearing out the rubble will be a good thing for the sector.

Prolonging the inevitable would be a big mistake.

Why any market intervention will make things worse over the long term.

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source: Stock Photo

The oil sector is a complicated market because there are a lot of conflicting interests becoming increasingly evident because of the emergence of the U.S. shale industry.

These divergent interests have always been there, but they're more visible because of the additional shale oil coming to market, which has underscored the weakness of a number of competitors which have been riding the market interventions of the past to prop up the price of oil.

What the shale disruption has done is remove that as a viable response to the oil glut and the resultant low prices, forcing competitors to wait for market forces to rebalance the supply and demand equation. This is why Saudi Arabia in particular has been so adamant about allowing the market to set the price of oil; it knows intervention will provide some artificial price support which will allow weaker shale producers to continue to compete. It also knows it would only be a temporary fix as it would extend the lives of shaky competitors which would have otherwise went out of business.

Who wants oil lower longer

Even though it has forced some national competitors to adapt to lower revenue as a result of the drop in oil prices, there are some in my view that are fine with that. Leading those few are Saudi Arabia, with other low-cost competitors like Iran and Iraq among the handful content with these market conditions.

You really don't hear much from these countries concerning a production freeze because they know it will hurt their competitive edge. They're, of course, lumped in with the narrative, but it's the high-cost producers driving the issue, not those that can still do well under these conditions.

Saudi Arabia understands this isn't another supply cycle the sector is experiencing, but a total disruption of the industry because of the increase in supply from U.S. producers. Attempting to intervene in the market in order to support the price of oil would only strengthen the U.S. industry and others that have costs better under control.

Not only will that extend the lives of the shale companies struggling now, but it would encourage the poor business practices of countries like Venezuela that make decisions based more on ideology than on the competitive market. This is why any intervention is a bad idea. It will only encourage the continuation of the same way of doing things without dealing with the reasons why they must change. For that reason, it's best for them to take the pain now and work on becoming more efficient than to allow that inefficiency to continue on.

Saudi Arabia, which in the short term didn't have to take these steps, has done so in regard to its budget. It understands the revenue from the past won't be the same in the future, and is removing some of the programs it had in place, halting non-essential projects, and cutting some subsidies it had offered prior to the disruption. The Saudis know there isn't a way to sustainably support the price of oil because it would only bring more supply to the market. It's the shortsighted competitors that aren't seeing this. They're only looking at the short term and how it will have an effect on their nations.

The oil industry needs to be cleared out

One of the great aspects of the market is it ends up removing the inefficient and uncompetitive companies that aren't able to adapt to fluid circumstances. The stronger companies survive and the sector strengthens and becomes more profitable over time.

There's a lot of rubble in the oil sector, and many of them that should go out of business may be given a chance to recover if there is some type of intervention. Investors in individual companies may approve of and desire that, but it's not good for the industry. No matter what happens in the short term, there will be a reckoning when the sector has to deal with the fact that a lot of oil will come to the market for many years, and anything artificially interfering with that will only delay the inevitable.

Since a number of shale producers, in particular, have significantly lowered costs during the same time others haven't been able to, inefficient companies shouldn't be given an opportunity to continue to compete if they can't become more competitive.

Besides the obvious reason, the market has yet to discover what the new price range of oil will be with the surge in supply, and any type of intervention, even if it only has a chance of temporarily supporting the price of oil, will make it impossible to find that price range. This is what the oil market needs more than anything, and why a production freeze would be bad for it, even if it would have a temporary and limited impact.

Weak companies should be allowed to be purged by the market and quality companies to acquire their assets.

This is extremely important to oil investors because it's not possible to get an accurate reading on where the market is pricing oil if there is any type of intervention outside of the market. We need to find a market-driven price, not prop up the price of oil to cater to uncompetitive producers. In other words, oil needs to become more entrepreneurial.

Conclusion

The price of oil, over time, will be pressured to be determined by the market and not outside interference. Why that is inevitable is because U.S. shale producers aren't going to hold back when the price of oil reaches profitable levels. OPEC can no longer dictate the price range of oil, it can at best only keep the price subdued by keeping the oil flowing.

That's why the production freeze is a joke. Most investors know that locking in recent production levels, which in many cases is at record highs, or, as in the case of Russia, a 30-year high. All that does is guarantee a consistent oversupply in the market. Some have even asserted it would lead to a production cut. That idea is so preposterous it is surprising someone would allow themselves to have their reputation take a hit from making that type of public declaration.

As for the price of oil, even though there is no one admitting it, there is definitely a reason why the lower cost producers want the market to weed out weaker competitors on its own. The industry is not only competing internally but against alternative energy sources. To prop up the price of oil in order to allow high-cost competition to endure would also give its external competitors more of an advantage. Low oil prices help the oil industry to slow down alternative energy competitors.

Since a number of U.S. shale producers have lowered their costs to competitive levels, it is also in their best interests to have oil remain under $50 per barrel, and in the short term, around $40 to $45 is a good range. That will allow the better companies to survive while their competitors are forced to sell assets, restructure debt, or close the doors altogether.

At this point in time, any oil competitor that hasn't reduced their costs to competitive levels doesn't deserve to be in business. There have been too many companies with quality management that have been able to do so.

I'm wary of any company that doesn't have a lot of liquidity and a good balance sheet, along with proven outcomes concerning lowering costs. They have a solid chance of not only surviving, but thriving in a world steeped in oil.

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.