Why would anyone sell seven widgets for $50 a widget (total revenue: $350) when they could sell six of the widgets for $100 per widget (total revenue: $600) and just keep the seventh widget in a garage to sell later? No rational person would do this, unless there were other considerations at work.
Yet this is precisely the current situation with Saudi oil exports. Few people doubt that Saudi Arabia could have held oil prices in the $100 per barrel range by cutting exports to six million barrels per day (bpd) as it did previously on several occasions over the past three years. Instead, Saudi oil exports have remained in the seven million bpd range. This together with weak demand in Europe and Japan (two of the world's four largest economies) has created a so-called "glut" in the oil market.
However, because demand for oil is inelastic, even a small amount of excess production is sufficient to drive the price down significantly. Similarly, a small amount of excess demand is sufficient to drive the price significantly higher, as we saw in 2008 when a minor supply shortfall combined with continued global demand growth (and a weak US dollar) drove the price of oil to $148 per barrel.
Global consumers simply do not increase or decrease their consumption of oil that much in response to high or low prices. This means that absent buying on a massive scale by the strategic petroleum reserves of China or the West the oil price will fall until the Saudis have determined that it has fallen far enough to accomplish whatever goal they are currently pursuing and decide to reduce their production.
Significantly, even the recent loss of 300,000 bpd of Libyan exports due to civil war in that country has not stopped the oil price decline. Indeed it appears that the Saudis have actually increased oil exports over the past few months to make up for lost Libyan production and to ensure that the supply glut remains. Curious behavior indeed.
I am not going to speculate on the reasons for Saudi over-production other than to suggest that despite the anti-US shale rhetoric coming from Gulf State oil ministers, the real reasons are very likely geopolitical in nature: Iran, ISIS, Syria, Russia. Which one is it? Beats me.
In any event, the US shale oil bubble was already in the process of bursting on its own, as subprime lending (i.e. junk bond issuance) to shale oil drillers was drying up and as the sweet spots in the shale patch were being fully developed. The Energy Information Agency (NYSEMKT:EIA) projects one million bpd increases in shale oil production each year into the middle of the next decade. However, the decline rates of existing wells is already so great that further production increases of even 10% or 300,000 bpd per year would have been extraordinarily difficult if not impossible to achieve. Currently, shale oil production is up only 15% over last year, not nearly enough to add an additional million barrels per day over the next year.
Already faced with declining rates of production growth despite massive increases in exploration and production budgets, shale drillers must now somehow hope to increase production while shrinking exploration and production budgets. Inevitably, with fewer wells being drilled, the decline rates on existing wells will overwhelm new production with total production turning negative. The US shale oil bubble will thus end rather spectacularly, with production flat-lining and then declining several hundred thousand barrels per day. Indeed, production is already down in November of this past year, although this recent decline may in fact be seasonal in nature rather than the beginning of the end of production growth. The real declines will come in the months following the first significant reductions in rig counts and completed wells, probably by mid-2015.
Rather than bouncing back when oil prices ultimately recover, however, shale drillers will likely find themselves largely shut out of capital markets and unable to expand production capacity significantly. Yet, if killing the US shale industry was the real reason for Saudi Arabia's actions, a decline to $70 or even $80 a barrel would have been sufficient. Instead, we have oil at $53 as of this writing.
With regard to the oil price, of course, global supply is not the entire picture. Global oil demand has been extraordinarily weak. Few people predicted that a graying OECD would reduce oil consumption (and imports) by as much as it has over the past decade. The only name I can recall is Harry Dent (whose primary focus is demographics and the economy). In any event, this trend is likely to continue as a very grey Japan and Europe become even greyer. Older people (typically those over 50) tend to drive less. Japan and Europe, with median age populations already in the mid-40s and with ever increasing number of retirees (and shrinking workforces) are not likely to be increasing their oil consumption anytime soon.
Since the developed world uses so much more oil per capita than the developing world, these demographic shifts in the first and fourth largest economies in the world will work to mitigate the impact of peak oil supply by significantly reducing the rate of global demand growth in the decades ahead.
Of course, what nearly everyone wants to know is, when will oil prices recover? Global oil demand growth will likely continue at an anemic 1% per year (or an additional 750,000 bpd) - almost entirely coming from the developing world. Over the past three years, this additional demand has been met by US shale oil drillers. In 2015-16, however, we will see that source of supply significantly curtailed. Thus, as long as the global economy continues to grow at least modestly, all else being equal, there will be a significant upward pressure on oil prices over the next two years as global demand growth is met by a shrinking rather than growing shale oil supply.
The wild-card, naturally, as always with oil prices, is Saudi Arabia. The Saudis have previously pumped over 10 million bpd and they are likely still able to so if they choose. Thus, with presumably some spare capacity left, the Saudis could meet global demand growth of 1% and shale supply destruction (likely several hundred thousand bpd). This would be in furtherance of whatever their current aims are. But for how long? Six months? Inevitably, absent global recession, the oil price will resume its upward movement.
Thus, longer-term the energy sector will outperform. At the moment, however, one can do nothing but sit back and wait for the oil price to reach whatever level at which the Saudis want it. In the future, the oil service sector (NYSEARCA:OIH) will outperform, as will the majors (NYSEARCA:XLE).
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The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.