Juneau, Alaska

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What Happened to Oil and what Happens Next?

A barrel of Alaska North Slope (ANS) crude oil was selling for $22.47 at the time this article was written. That’s down 67% from the beginning of the year. In terms of the state’s royalty oil, that price swing represents a reduction of almost $3 million per day. For the producers, it means that they are paying more money to pump and transport the oil than they can sell it for. So, what happened? And, perhaps more importantly, what is going to happen next?

Why do we care?

Before diving in too far, let’s get one thing straight. Alaska runs on oil. Not every region has the same direct tie to the industry, but our state economy thrives and withers whenever the price of oil rises and falls.

Oil money fills our General and Permanent Funds – which pay for our roads, schools, law enforcement, and everything else the state government does. Directly or indirectly, it is the oil industry that supports the services we receive without requiring a tax from us. Those benefits reach into every corner of the Last Frontier.

It is also the oil industry that creates the jobs and wages that allows money to circulate in our economy. And, our PFDs are a direct result of past oil revenues. For the last five years, oil prices of the day have also led directly to the size of our dividends.

The positive impacts of the oil industry on Alaska’s economy cannot be overstated. Combined with the fishing, mining, and timber industries, the development of our natural resources is the most important economic driver in the state. That is why our constitution calls for us to promote natural resource development.

It’s all about supply and demand

So, what happened to oil? Like any other commodity, good, or service on the market, oil is subject to the laws of supply and demand. The market uses price changes to signal buyers and sellers on how to respond to changing market conditions. When there is more oil on the market than people are using, prices fall. That encourages buyers to buy more and sellers to bring less to the market. When there isn’t enough production to meet demand, prices rise. That encourages buyers to cut back on how much they use and tells producers to invest in more supplies.

In theory, the market is always moving toward balancing the available supply with the consumption levels. Of course, the market isn’t static, and the system for buying and selling oil is complicated. So, prices are constantly moving based on changing conditions and based on speculation about where things are heading. Predicting the future price of oil is impossible. But, the fundamentals always rule. The laws of supply and demand don’t disappoint.

Production and Consumption

The following charts come from data provided by the Energy Information Agency (EIA).

The figure above shows the relationship between production and consumption. As shown, the general trend has been increasing consumption. That was mostly coming from China and India, as their economies grew. To satisfy the growing demand, oil companies developed more supplies. If those two factors grew at the same rate, prices would stay flat. But they didn’t.

The next graphic shows the imbalance between production and consumption. There is something that should stand out. The right side of the graphic shows an enormous oversupply of oil. Referring back to the graphic above, you can clearly see the decrease in consumption. That is the effect of everyone staying home rather than driving to work and going on trips. Because supplies can’t shut off nearly as fast as consumption, you see the gigantic oversupply.

Now, compare the periods of oversupply to the changes in prices on the next graphic. You should notice they line up. That’s good, since that’s what the entire field of economics rests upon. When there’s too much oil, prices fall. When there’s not enough oil prices rise. And, when there is about the right amount of oil on the market, prices stay the same.

CSV  

What Happens Next?

Nobody can tell the future. But, we can use clues from the past, along with an understanding of economic theory, to paint a picture of what to expect. There are basically three things that are going to matter over the next several months.

Demand Recovery

First, when demand recovers, prices will rise. Right now, there is so much more oil on the market than refiners and petrochemical plants can use, producers are begging them to take their oil. Once people start driving, traveling, and shopping again, that demand should recover. At that point, the producers will have a little more leverage to get a better price.

The thing to watch is whether or not demand really does recover back to previous levels. It’s possible that all this working from home turns into a permanent deal. It’s possible that people stop flying around the world so much after this whole thing is over. And, it’s very likely that the coming recession will reduce the ability for people to purchase things at the same rate as before. So, we might see some level of demand destruction going on here.

On the flip side, low gas prices imply that people might take more road trips. It could mean cheaper airfares, which should increase the amount people fly. And, lower energy costs tend to translate to cost reductions across the manufacturing and transportation sectors. Lower costs can lead to lower prices for consumers, especially in a highly competitive environment.

Production Cuts

On the supply side, watch what happens to oil companies. We’ve already seen a willingness for OPEC+ to come back together and make an agreement to voluntarily reduce production. That alone should put a floor under prices. We will have to see whether or not countries actually follow through on the cuts.

But, regardless of the agreement, companies are seeing their cashflows evaporate. For some, they are already losing money by continuing to pump oil. At some point, they will have to shut it down rather than accept further losses. Here is what happened to US Shale production after the 2014 price crash.

First, companies stopped drilling. That can be seen in the rig count numbers. Then, the lack of drilling led to reduced production. That can be seen in the second chart.

The same pattern is emerging now. In fact, the shale producers had already started cutting back on drilling before the price crashed. That is because investors were becoming impatient with the constant need to reinvest all of the revenues. But, it looked as though things were stabilizing until a few weeks ago. Now, the rigs count is in free fall. Therefore, it’s likely that falling shale oil production will help rebalance the market. It’s even possible that this lack of investment will lead to a rebound in prices once the current glut clears.

However, one thing to watch out for is the ability for shale producers to reduce costs. Before prices collapsed in 2014, the cost of drilling and producing a new well was around $75 a barrel. After the crash, companies brought that cost under $50. Once these companies go bankrupt and the resources get consolidated, it’s possible that the marginal cost of supply will fall further. If so, it will be difficult for prices to climb back to previous levels.

Storage Constraints

The one thing that could be disastrous for oil prices is for producers to run out of buyers. Imagine the situation in which nobody can buy oil because there is nowhere to put it. A producer would have no choice but to stop pumping oil. In theory, the price of oil would be zero. The consequences of doing that would be significant, especially on the North Slope.

Of course, there would still need to be enough oil pumping to meet real-time consumption. But, that might mean that only the cheapest 80 million barrels a day would continue production. The other 20% of the global market would shut down.

There is no official count of available storage. Most of it is privately owned. But, analysts estimate the number at up to six billion barrels. There is already an estimated three billion barrels in storage or more. Given the preliminary estimates of production and consumption in April, there are nearly 100 billion barrels of oil produced and only 80 million barrels consumed. The gap of 20 million barrels per day would need to go into storage.

At 20 million barrels per day, that’s 600 million barrels per month. The most pessimistic assumptions give us about six weeks before we completely run out of storage. Regional storage constraints may run out sooner. Of course, closing the gap between production and consumption would mean the fill rate slows down. That is why the OPEC+ agreement is so important (and probably why it happened). The 10 million barrel per day reduction won’t balance the market. But, it should avert the catastrophic outcome of running out of storage.

Outlook

The EIA currently predicts that demand will recover in June. From there, they assume that production levels will remain low while consumption recovers. That situation should persist until the storage situation gets back to normal (which could take well over a year).

The implication is that prices shouldn’t get much above the $20s until demand catches up. Then, it should rise into the $40s while the storage situation gets addressed. The longer it takes to get demand going again, the longer oil prices will stay in the teens to twenties, and the longer it will take for the building storage to clear. If demand stays low enough for long enough, prices could fall even further.

But, this situation should resolve itself over time. It might clear even faster if other global events remove supply from the market. Within a few years, we should be back in balance with prices climbing back toward that equilibrium price of $65 or so. And, it is possible that something crazy will happen and change all of these dynamics before we get there.

Bottom line: Don’t confuse what’s happening in the markets today with some sort of new reality we are living in forever. Economic theory tends to work. Oil prices will not stay where they are unless we decide to stay in quarantine forever.

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