Last week the price of oil broke below $30 (U.S.) a barrel and stock markets tumbled. Now some analysts are saying a retreat to the $20 level is a real possibility as none of the major producers shows signs of reducing output.
A few are even more pessimistic. Standard Chartered, an international banking group based in London, predicted last week that oil wouldn't bottom out until it reaches the $10 a barrel range, a level not seen since 1998.
"Given that no fundamental relationship is currently driving the oil market towards any equilibrium, prices are being moved almost entirely by financial flows caused by fluctuations in other asset prices, including the dollar and equity markets," the bank said. In such circumstances, oil will not start to recover until such time as "money managers in the market concede that matters have gone too far".
In response to the continuing rout, oil companies are once again slashing capital budgets and trimming jobs. BP announced last week it would cut its global workforce by 5 per cent, or 4,000 positions, as part of a multi-billion dollar restructuring program. Earlier, ConocoPhillips reduced its 2016 capital expenditure budget to $7.7-billion, down 25 per cent from the estimated 2015 total and 55 per cent from 2014. Similar announcements have been flowing from the energy sector for the past year.
It all sounds terribly grim and the deep dive in the markets has left investors fearful of worse to come. Unfortunately, we're not likely to see any immediate relief. But as far as oil is concerned, don't lose sight of the fact that we've been here before and managed to survive. In fact, according to the U.S. Energy Information Administration (EIA), the price of West Texas Intermediate (WTI) oil has fallen by at least 50 per cent on five occasions since 1986. This is nothing new.
Back in 1997-1999, the price of oil collapsed during the Asian financial crisis, dropping as low as $10 a barrel. Adjusting for inflation, that was the lowest price since at least the end of the Second World War. Interestingly, that was also during an El Nino period, which produced mild winters that cut demand just at a time when producers were pumping at the maximum.
Those were tough times for Canada in general and Alberta in particular. Just as we're seeing now, there were mass layoffs and huge cuts in capital expenditures. About $2-billion was slashed from 1998 capex budgets compared to 1997 spending. Energy service companies saw their business drop by as much as 50 per cent. Alberta's housing market went into a deep slump, to the point where home abandonment due to high mortgage costs became a serious problem. And it wasn't a short-term slump – the low prices continued from November 1997 to December 1998, a total of 391 days.
Many of the same global effects that we saw then are repeating today. Russia came under extreme financial pressure and was forced to devalue the ruble and suspend interest payments. The Venezuelan economy almost collapsed as oil revenue fell 37 per cent between 1997 and 1998. Saudi Arabia experienced a drop of about 35 per cent in revenue, resulting an increased deficit.
The crisis of the 1990s only ended when Saudi Arabia and some other producing nations decided that enough was enough and closed some of the spigots, reducing supply. The current crunch will almost certainly be resolved in a similar way. The x factor is timing.
So far, no one is showing any signs of blinking. But as the price continues to drop, more companies are finding themselves in a financial bind. There's a lot of dispute over what constitutes break-even for production costs but a paper published last year by the University of Calgary's School of Public Policy cited reports from BMO Capital Markets and TD Securities that estimated the WTI breakeven price of production from existing conventional facilities at between $16 and $51 a barrel. For mining (oil sands) projects the cost range was put at $34 to $54 per barrel.
Clearly, at current price levels many companies are facing operating losses. How long this can go on is anyone's guess but analysts (and bankers) are going to be keeping a close watch on fourth-quarter and year-end financial reports in the coming weeks. AlixPartners, a consulting company, estimates that North American producers are losing about $2-billion per week at current prices. RBC Capital Markets says that since the oil price plunge started, more than 30 small companies, with collective debt exceeding $13-billion, have filed for bankruptcy.
Even when the oil price bottoms out, it may take years before we're back to 2014 levels. After the energy depression of 1997-98, the price remained stuck in the $20 to $30 a barrel range for several years. It only began to move sharply higher in late 2004. At that point, with demand from China growing exponentially, it rocketed all the way to $147 before the financial crisis of 2008 sent it tumbling back down to around $40.
Obviously, there will be tremendous profit opportunities in the energy sector when the next up cycle begins. But as matters currently stand, there is no reason to believe we're close to that point. Since the price isn't going to fall to zero, there's less downside now than there was a year ago. But the risk for investors remains elevated, especially in the case of smaller producers. Bide your time for now.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. Follow him on twitter @GPUpdates and on Facebook.
Gordon Pape