Oil Has Peaked

| About: The United (USO)

Summary

Most people think oil will slowly trend upward in price.

However, there is a price ceiling due to frackers.

Frackers, although many broke, still have tons of easily ready equipment available to exploit price increases.

The conventional wisdom says that oil prices will slowly recover and that they will continue to steadily climb. In fact, Morgan Stanley Research projects that West Texas Intermediate will reach $75 per barrel by the end of 2018. They are wrong for a variety of reasons; chief among them being the growth of the North American fracking industry, and the flexibility and elasticity that this brings to the market. However, let us start off with geopolitical factors that may actually increase the global oil supply short term.

Saudi Arabia has a vested strategic interest in keeping oil prices low, and not enough incentive to increase them. The kingdom currently has around $600 billion in FX reserves, and was burning through around $100 billion per year with oil around $40. At oil's current price, these losses are diminished a bit, and more importantly, they are inflicting economic pain on their main geopolitical rival in the Middle East, Iran. Iran itself, having reduced its output due to sanctions, has stated that it would like to ramp up to its pre-sanctions level of production, which is at 4.5 Mbd. They currently produce 2.5-2.8 Mbd. The increased supply of this oil coming onto the market in the coming years can only serve to keep prices down, especially when combined with the fact that OPEC could not agree on a production cut at their June meeting.

The main reason oil will stay around 50 dollars per barrel though is U.S. fracking. Econ 101 tells us that in a perfectly competitive market, eventually, the price that a good is sold at will reach the price of production. If oil goes up, more fracking will just come online, and drive the price back down. The cost to produce per barrel of fracking is outlined in the chart below. Keep in mind though that this chart is from 2014 and many oil companies made strides in their efficiency as prices crashed, and that the true number is likely to be lower.

Click to enlarge

As you can see, there are a large number of frackers whose breakeven point is around $50 per barrel. However, shouldn't the Saudi's insane increase in production have put them out of business? It did, but that doesn't matter.

All of the physical infrastructure for fracking is still in place. The old wells from bankrupt companies still exist. The pipeline networks to transport their product still exist. The expertise and special skill set that oil engineers and workers have still exists. Most importantly, the companies that survived still exist and can scoop up the bankrupt ones' assets and at bargain prices and start drilling again. Because of all of these factors, the fracking market is relatively elastic. It can respond quickly to changes in price fluctuation. The average lag time for rig count to respond to price change is 122 days. With these relatively quick response times, and the almost unlimited capacity that the US shale fields possess, it is hard to see oil climbing and staying anywhere above $50 for a long time, simply due to basic economics. World demand is also not likely to pick up soon, with the global economic growth nowhere near high enough to tangibly affect demand and thus prices.

Disclosure: I am/we are short SPY.

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.