Pump And Dump?

by: Douglas Tengdin, CFA

Oil prices are down over 50% from a year ago. They're at a six-year lows, and apart from the financial crisis, the last time we saw crude below $40 was in 2004. If prices stay this low, gasoline should cost less than $2 per gallon soon.

Basic economics teaches that when prices fall, producers adjust by reducing their output. After all, higher prices made it profitable to bring more product to the market-at a higher marginal cost. Why aren't lower prices creating production cuts-a supply response? But in July, OPEC increased its production, and it has remained stubbornly high.

Crude Oil Price (White) and OPEC Production (Yellow)

Source: Bloomberg.

The short answer is, they need the money. These producers have government budgets that depend on their oil revenues. The more prices fall, the more they need to pump to make up their deficits. In the short run, it costs them so little to get oil out of the ground that their fields are still profitable, even at lower prices.

The main impact of the current price level has been to cut back on new drilling, rather than slowing the flow of oil from existing wells. That means that lower prices today impact future supplies more than present production. Right now, the excess inventory is likely to persist, or even grow, until demand catches up with supply.

So who's going to win this price war? On the one side is OPEC, with the biggest and cheapest oil fields in the world and budget deficits that need more cash; on the other side are U.S.-based frackers, with hedged production, local demand, and political stability. OPEC needs to keep pumping, the frackers need to drive down costs.

Whichever side triumphs, one group has clearly come out on top: consumers. Low oil prices are going to be around for a while.