There is no doubt that one of the most important trends in the entire global economy over the past year has been the unexpected collapse in crude oil and energy prices as a whole. Almost no one saw it coming, yet it has driven much of the swings in global markets since 2014. Low oil prices have changed consumer trends, reversed the fortune of energy producers, and caused GDP reductions in oil hubs like Canada, Russia, and Saudi Arabia. It has changed economics both within and between countries and companies, and helped contribute to record low deflation in most industrialized markets.
I know that there has been extensive speculation over what the future holds for oil, and I do not wish to be repetitive in my analysis. My goal in this article is to analyze the oil market from an economics perspective and use economic theory, along with real-world conditions, to explain why there will continue to be downwards pressure on oil prices. I will not attempt to calculate the intrinsic value of oil or determine specific target prices, but explain the overall trends of which investors in the energy sector should be aware.
Before I delve specifically into my argument on oil, I want to provide background on the concept of residual demand, which I believe is the best economic model/theory to explain the current dilemma. Residual demand is a microeconomics concept that describes how a one manufacturer/producer will operate in a competitive oligopoly. The model assumes that the number of producers is finite and known, and that all producers create a single, identical good which is sold on a global market. Since there is no differentiation between the goods, all firms must sell their goods at market prices.
The model/concept is a slight alteration of the basic supply and demand functions for the overall market. Essentially, the model states that any individual firm can construct its individual demand curve for its goods by taking the market demand and subtracting out the demand from all other firms. This is useful because the producer can project how any changes in the market will affect the firm's price and optimal production levels. For example, if other firms increase production, the firm can estimate the new market price, and adjust its production levels so that its individual demand curve equates with its supply.
Even better, the firm can project how any changes in its production level will affect the overall market price. For instance, if the firm decides to expand production, it can calculate the new market price by equating market demand with the new market supply. The only assumption required is determining whether the other firms in the market will increase, decrease, or maintain their production levels. The exact quantification of market supply and demand is difficult, but the model provides a rough approximation that allows the firms to anticipate how its decisions will impact the market price and its individual demand.
The residual demand model works well in describing oil producers because many of the model's assumptions align with the dynamics of most commodity markets, including crude oil. For example, the oil market is a competitive market because there is no differentiation in the end product-crude oil- from producer to producer. For this reason, oil producers are required to sell their oil to refiners and other customers at a given market price. The only way an individual entity can control price is by expanding or reducing production, which impacts the overall supply and demand for the market. Since the market meets these assumptions, it stands to reason that individual oil suppliers react in the manner described by the residual demand model.
The advantage of using the residual demand approach is that it does not take a broad or macro view of the market, but contextualizes the choice of each individual supplier given the structure and forces of the overall market. Of course, this gets into the traditionally-rousing debate about whether micro or macroeconomic study is more important to explaining economic phenomena, a topic which is far beyond the scope of this article. However, the oil market is strongly determined by the production quantity decisions of oil drillers, as I explain below. Therefore, we can understand the dynamics of the market if we look at production decisions from the perspective of each producer using the residual demand model.
The global demand for oil is highly inelastic, which means that demand is only weakly correlated with price (and that a shift in price only causes a minor change in demand). While it is difficult to exactly quantify elasticity, economists have speculated that it has fallen over time, and that oil is one of the most inelastic goods/commodities on the planet. This trend can be seen in the data, in which the global demand for oil has fluctuated by less than 10% for 2007-2014. Even with falling oil prices, global consumption increased by only 1.3% in 2014, and is projected to increase by about 1.2% for the remainder of 2015 and 2016. In fact, in OECD countries, oil consumption fell by about 0.5% in 2014 and remain fairly constant in 2015 and 2016. The growth engine for oil has been emerging markets and China (with more vehicles on the road due to rising incomes and the development of infrastructure), but economic uncertainties in these markets have caused growth estimates to be revised downwards for this year and next.
Conceptually, it makes sense that demand for oil is inelastic- we need to use oil to drive to work, fly to other cities, and ship goods across oceans, and we have little realistic option besides to consume oil as a fuel for these activities. To that end, oil usage is correlated to overall economic activity than price, which explains why consumption fell during the recession and rose in 2012-2013 despite record high prices. Even so, the only major deviation from a steady 1-2% annual growth in oil consumption in the last 10 years was during the 2009 and 2010, meaning that only it would take a major market collapse to affect the overall demand for oil.
For this reason, the highly inelastic demand for oil means that the market has been defined more by oil supply during recent years, which helped fuel the crash in oil prices. Though lower than other commodities, the elasticity of oil supply is greater the demand, and supply has been more volatile than demand in recent years.
In this regard, the residual demand model describes the oil market well insofar as it contextualizes the choice of each individual supplier given the structure and forces of the overall market. Demand is exogenous and relatively constant (for our purposes), so the one variable on oil pricing which can be changed is supply. If we understand how and why oil drillers make their decisions, then we can directly relate these decisions to oil prices and the overall market.
Application of Residual Demand: When Will Oil Producers Cut Production?
It seems natural to anyone that has taken an introductory-level economics class that when an exogenous variable lowers the price of a good, the supply of that good should fall. The mechanism behind this logic is that a firm will cut production in order to increase the revenue per product while decreasing marginal cost, thus increasing profit from where it would have been otherwise. However, using the residual demand model, we can see how that simple logic does not apply in the oil market.
As I described earlier, the key to residual demand is the fact that all producers make their decision in the context of the broader market. If one firm wants to increase price, the only way they can accomplish this goal is by reducing their individual production, and hoping that they control enough of the market to have a material impact on the market price. However, if no other firms cut production, than all of the other firms would reap the benefit of the sole firm's production cut through a higher price of each individual good. Meanwhile, the sole firm who cut production would typically be worse off because their loss in goods sold would outweigh the gains in marginal revenue (since other firms held production constant).
As this thought experiment illustrates, the only time a firm in such a market would be able to benefit from a cut in production would be if every (or most) other firms in the industry likewise cut production. If that company believed that its rivals would not cut production, its optimal course would be to hold production constant or otherwise maintain its original production plan. Alternatively, if a firm wanted to increase production, it would only see a benefit from the increase if all/most other firms held production constant, which would potentially allow the growth in products sold to outweigh the inevitable drop in marginal revenue.
If we apply these concepts to the oil market, we can see why it is so difficult for a country, company, or organization to take the rational economic step and cut production.
Every single entity knows that it is their best interest to cut production: supply is continuing to exceed demand, and is continuing to grow at "breakneck speed" according to the IEA. The growth in inventories from excess supply has continued to be a catalyst for falling oil prices so far in 2015. From an economics standpoint, the market is inefficient because supply and demand at the current prices are not equated.
Despite all these factors, the reason that no major entity has cut production is that the cost of being the first firm to act is too high. Using the residual demand model, we know that one entity should cut production only if it believes that others will. However, no one company wants to be the first to institute a major cut in production because it would have major short-term ramifications for that entity. The first entity would have to suffer through several quarters of lower revenue and profit due to having fewer barrels of oil to sell. In turn, this drop would squeeze their cash flows, leaving them with fewer exploration and capital expenditures funds when the oil prices should reverse. Cutting production would also result in a loss of market share with only a minimal effect on price, a risk that many companies are not willing to take. Though it may help the global oil market, cutting production would place that company/country at a competitive disadvantage relative to its peers, at least in the short term.
In addition, no entity has been willing to cut oil production because they do not anticipate other entities cutting production. Many firms, countries, and organizations have openly refused to cut production; most notably, OPEC has kept production quotas on the same target and openly resisted any cuts. The primary reasons why most entities believe that their rivals will not cut production are explained in the following sections.
Need to Cover Costs
You may be thinking that the rational action for all oil producers, whether OPEC nations or U.S.-based shale drillers, would be to simultaneously cut production by similar percentages to eliminate the problem of excess supply. This is, after all, the solution which economics prescribes when supply outstrips demand, excess inventory builds, and market prices are halved. Certainly every producer would be better off with the higher marginal revenue and decreased total costs from production cuts. However, there are many other factors which reverse the macroeconomic rationality, even though each producer individually is acting rationally (a tragedy of the commons, of sorts).
The first reason why companies believe their rivals will not cut costs is because of they need to generate cash to cover their expenses at present. This factor most prominently affects North American drillers in shale and sands oil, as well as some countries whose economies rely extensively upon the sale of crude oil. For the most part, shale drillers' sole source of revenue is the sale of unrefined crude oil, meaning that their revenue is directly related to the price of oil. This logic also applies to oil-dependent nations such as Saudi Arabia, Venezuela, and Russia, in which oil dominates at least a plurality of their GDP. As oil prices have fallen, the revenue for these entities from oil extraction has fallen dramatically, with some losing as much as 50% of their previous top line numbers in 2013.
In general, economics tends to focus on marginal and/or variable costs, which are directly related to the amount of production that an entity produces. However, oil extraction requires extensive capital, which leaves oil drillers with very high fixed costs that are independent of production. These companies can lay off employees or halt oil rig usage, but they cannot escape the financing costs associated with owning their capital.
Among shale oil companies, one of the primary concerns is simply avoiding default and staying in business. Many of these companies became highly levered in order to acquire the funds needed to finance the shale oil boom and capture the market, and making payments on their debt has become more difficult with low prices. Specifically, the interest expense as a share of revenue among 60 U.S. shale oil drillers averages around 12%. For 1/6 of these companies, the share of interest expense is as high or exceeds 20%, with the highest level at around 48%. At this point, it is next-to-impossible for these oil drillers to secure lines of credit or raise money in capital markets because everyone is aware of their already-precarious situation. Though these companies have other fixed costs, meeting their interest payments is their primary concern in order to stay in business.
Using this analysis, the residual demand model explains why these companies have increased production, despite the fall in oil prices. Morningstar and another analytics firms have estimated the marginal cost of shale oil extraction to be between $80-90 per barrel, and other firms have placed the overall breakeven price to be about $70-75 per barrel. Therefore, shale drillers are losing money on every single barrel of oil they pump at present. Moreover, because of the high fixed costs associated with production (purchasing extraction rights, owning rigs and equipment, etc.), cutting production might actually increase the marginal cost and widen their losses.
Thus, the best response for these companies according the residual demand model is actually to increase production. On one hand, these companies know that the major oil producers are not going to increase production since prices have fallen so far, and may even be below marginal cost for cheaper extraction methods. At the same time, shale oil producers do not have a major market share presence compared to OPEC (about 40% of the global market) and other top oil drillers. Therefore, shale drillers can expand production without significantly dragging down the price of oil and flooding the market with excess supply. With oil already having fallen so far, the gain in revenue from selling additional barrels will offset the fall in oil prices from increased production. At the end of the day, these shale drillers need cash flows in order to pay off their debt and other expenses.
The same logic applies not just to shale drillers but to countries whose primary export is oil. These countries heavily depend upon oil for tax revenue to avoid sustained budget deficits and maintain their economic viability. For example, the fiscal breakeven price for top oil producers range from a low end of $80/barrel in Qatar to a high of $180/barrel in Libya, with major producers like Russia Saudi Arabia, and Venezuela needing oil prices to be about $110/barrel to avoid deficit spending.
Obviously, it would be best for all of these countries to collectively cut production to increase the world price of oil. But as the residual demand model shows, if one country cuts production, than other countries will simply fill the gap in production while the benefits of higher prices. Therefore, the only way for these countries to bring in more cash is to maintain and/or expand production and expand their share of residual demand. Many of these countries do not have extensive reserves and face high borrowing costs, meaning that they ultimately need cash at present to pay their bills.
It is worth noting that the IEA disagrees with my interpretation of the model, and they have forecast shale oil production to fall 9% in 2016. Their argument is that oil extraction requires continued investment to sustain growth, and shale oil drillers cannot afford the requisite investments.
However, I disagree with the assessment because it simply does not match up with the data and economic theory. In June, the active rig count for shale oil drillers actually increased for the first time in 7 months, and analysts estimate that shale drillers could add over 100 rigs by the end of 2015. Additionally, shale drillers have shut down their less efficient rigs and cut costs to reduce their marginal costs of extraction by as much as 25%. They also are benefiting from lower rental prices on land suitable for extraction due to the lower value in oil.
But most of all, these firms will not cut production because it would take too long for the global oil prices to adjust. These firms are stripped of cash and need to continue generating cash, and their only way to do that is to increase production. In fact, the IEA recognized this just two months earlier and had forecast shale oil production to increase 2% in 2016. Therefore, I believe the IEA's forecast has merit, but it will take a longer time to come to fruiting, in part because of the next two factors as to why producers will not cut production.
It is not secret among any oil producers that the fall in oil prices has gone hand in hand with a global battle over oil market share. In fact, the fight for market share runs contrary to economic rationality because it has flooded the global oil market in excess supply, resulting in a sustained 50%+ plunge in crude oil prices.
To me, the market share fight is entirely about politics and power, particularly from the side of OPEC. Ever since its creation, OPEC has been the world's largest oil exporter by a wide margin, and their market share has given them vast power and influence over the global oil market, to the tune of at least 45% of the global oil market in many years. Since their residual demand (as an organization) is such a large percentage of the global market, they have been able to strongly influence oil markets through their quotas and policies.
While OPEC is still the world's largest oil exporter, its market share has been threatened over the last two years by increases in production from other sources. Most notably, Russia and especially U.S. shale drillers have grown their production quickly while OPEC's has remained constant. In 2014, OPEC's global market share fell from 43.3% to 41.8%, which was its lowest level since 2003. This year, OPEC's market share is expected to further diminish as U.S. production has increased throughout the year thus far.
The problem is that this entire strategy relies on OPEC maintaining its global dominance that I described before, which allows OPEC's quotas to set oil prices due to the residual demand under its influence. Now, U.S. production is continuing to increase, and there is nothing that OPEC can do about it. This tremendously weakens both the power of the organization and the incentive for each member to follow the production quotas it sets. After all, these nations are being hurt because prices are falling even though they have been strictly controlling production, leading to a drastic fall in revenue from oil sales.
Using the residual demand model, we can see why OPEC is reluctant to cut production. If OPEC were to cut, this would immediately cause a spike in crude oil future and quickly increase the revenue for all member nations. The problem is, it would also increase the revenue for shale producers, and more importantly, allow more cash for future exploration and extraction to flow to these firms. For this reason, the growth in U.S. oil exports would at minimum remain constant and perhaps even increase in the following years, In order to sustain the prices generated by a cut in quotas, OPEC would have to continually cut production to offset the increased production from the U.S. The result would be continually diminishing market share for OPEC, and potentially a decrease in total revenue depending on the production cuts required to return prices to a higher level.
OPEC economists have predicted this exact future. They know that, as many analysts have suggested, the organization is at a crossroads in which its power could significantly diminish. For this reason, OPEC has launched a "price war" to maintain their vast residual demand and control of the market. Though they need higher oil prices to balance their budgets, most OPEC members have a lower marginal cost of extraction than U.S. shale drillers, so they will sustain fewer losses even in a low price environment. OPEC also knows that if prices remain low for a prolonged period, U.S. production will fall since drillers have no cash to invest in exploration or new equipment.
From the perspective of any individual entity, it does not make sense to cut production in this global context. Oil prices largely have been responsive to U.S. shale and OPEC output, both of which will not cut production for the reasons I have illustrated here. Thus, if one single firm were to cut production, the only result would be to shrink its market share and its residual demand, resulting in less revenue and prices that are no higher. It does not make sense for any entity to cut production unless a larger market participant gives up the fight for market share.
Belief that Oil is Oversold
The final reason why no entity (U.S. drillers, multinational driller, OPEC nation, or otherwise) believes that others will cut production is because there is a prevailing sentiment within the market that oil is trading below its intrinsic value. For many, it feels that oil has fallen too far too fast, with the only real catalyst being about a 2% annual growth in the production of U.S. shale oil. Supply has exceeded demand for the last several quarters, but many feel that itself is not enough to push oil down 60% from its peak 2014 levels.
OPEC has been at the forefront of this argument, and it has been a peak argument against cutting production (although this is largely because OPEC does not want to directly say that they are in a price war with rival producers). Many OPEC nation leaders have been discussing a fair price, with some estimates as low as $70-80, while others target about $100. These individuals correctly contend that global demand is growing and that will eventually normalize prices. Additionally, there is a general feeling that commodity futures trading tends to overshoot the underlying movements in value, which should produce a type of normalization effect.
Like any economic phenomena, the question is not if oil will rebound but when. What needs to occur for prices to rise for supply to contract, at least to end to excess supply that is being produced in the current market. As I said earlier, inelastic demand means that the market adjustment needs to occur on the supply side. As low oil prices persist, companies with high marginal costs of extraction and high debt (U.S. shale drillers mainly) will be forced to cut investment and exploration funds, and many have even idled several rigs which are not as efficient/profitable. Without new investment, the growth rate of U.S. oil production will eventually turn negative, allowing supply and demand to equate (and for the price of oil to rise).
The problem is that the reversion of oil prices may take several years to take effect. Though investment may finally be slowing in 2015 for U.S. producers, the past investment for the firms may be able to sustain production levels for a numbers of years. For example, capital expenditures totaled $200B in 2014, a 15.6% increase over 2013. Other factors in oil production, such as property acquisition, R&D, and exploration increased 20%, 15%, and 6% respectively in 2014. Even though many companies are planning to scale back their investments this year, investments usually pay off over time, so the high investment levels in 2014 will fuel increased production for at least a few years.
Returning the residual demand model, companies are unwilling to cut production now because they want to have as much residual demand/market share when prices do eventually rise again. If a company/entity could gain market share while the price is low, and hold on financially until price rises, then they would outperform their peers who remain stagnant in the future. By cutting production when other don't, it would be impossible for firms to gain market share and take advantage of eventually rising prices.
As I said in the beginning, I am not trying to reinvent the wheel with this article, and come up with a foolproof method for analyzing the intrinsic value of oil by any means. Rather, my goal is to analyze the oil market from an economics perspective by examining the decision of oil suppliers, who have much more influence on market prices due to the lack of demand elasticity.
By using the model of residual demand, we can see that it only makes sense for one oil producer to cut production if they believe that others will follow suit. However, there are many reasons why others especially OPEC and U.S. shale drillers, will not cut production in the near future. Without either of these groups cutting production, the price of oil is unlikely to rise significantly in the near future.
I do not have a specific timeline for when I believe that oil prices will begin to reverse themselves. I believe the best approach is to continue to monitor output from U.S. shale drillers and OPEC. Should shale oil production begin to fall, I believe oil prices will begin a long awaited turnaround. This may take place in six months or it may take place in five years. No one knows what will happen, but it should be interesting for investors to watch.
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.