When an asset class takes a swan dive off the cliff, fortunes can be lost trying to call the bottom. It's often impossible to tell whether the asset in question is on a suicide run or undergoing a short-term correction. And so it is with oil.
Oil prices are down by a third since June and are less than half of their 2008 high of $147 (U.S.) a barrel. So time to buy? If I knew how to call bottoms, I would not be a miserable, ink-stained wretch; I would be filthy rich and living in a villa on the Amalfi Coast or Côte d'Azur, martini in each hand. But allow me to present four ideas of why the foundation for a compelling oil price bounce-back is being set even as prices tumble. I'm just not going to tell you when that might happen, because I have no clue.
The best cure for low prices is low prices.
In the late 1990s, oil, in nominal dollars, fell to $10 a barrel and the Economist famously predicted that $5 oil was coming, a call that, 25 years later, still haunts the magazine like an obsessed lover from your youth. Of course, the low price stimulated demand and drivers flooded into showrooms to buy rolling, gas-slurping pigs like Ford Explorers. At the same time, the low price choked off exploration and development, constraining supply.
By 2005, oil was at $60 and would more than double again before peaking out and crashing during the financial crisis – just as low prices cure themselves, so do high prices. We don't know if the current price of $70 a barrel can be considered low, but we do know that prices in the $60-to-$70 range will hurt the high-cost producers, a group that would include the deep-well offshore operators, the oil sands and some of the short-life U.S. shale oil wells (Société Générale says the big American shale plays, such as the Bakken, need about $65 to keep pumping). As capital expenditure budgets get crunched – and they're getting crunched now – supply will eventually fall. But that may not happen quickly because the big production projects that are already under construction can't be cancelled or slimmed-down. But rest assured, it will happen.
Peak oil is real, depending on how you define oil.
Euan Mearns, an oil analyst I like a lot because he is independent and not really an analyst – he's a geologist and good researcher who strays off the beaten path – produced a fascinating little chart recently on his Energy Matters site. The chart showed that conventional oil and condensate – the "black" oil that comes out of the ground easily and relatively cheaply and can be refined into gasoline – reached a production level of 73 million barrels a day in 2005. Guess what? Almost a decade later, conventional oil production has not climbed even though prices were high for most of that time.
What drove global production up to the current 92 million barrels a day or so was non-conventional production – the oil sands, U.S. shale oil, biofuels and natural gas liquids. The problem is that most of this production is highly expensive and a lot of it, like the gas liquids, is refined into heating fuels, such as butane, not transportation fuels, which are the biggest oil products market. Barring a technological breakthrough, the world has probably seen "peak" conventional oil production. That means any significant production gains will have to come from non-conventional oil. Continued low prices can only damage that production.
The e-car revolution isn't.
To listen to Elon Musk, the Tesla e-car founder, and other locomotion-by-battery cheerleaders, e-cars are set to make huge market inroads after finding themselves parked on the sidelines for a century. If they are right, global oil demand will fall and the price will react accordingly, since cars are the biggest users of oil. And wouldn't it be nice to see our streets plugged with quiet, clean electric machines instead of cars powered by C02-belching internal combustion engines? The flaw in the vision is that the e-car revolution is nowhere in sight. The U.S. market for e-cars and hybrids – the latter are cars powered by batteries and gasoline engines, like the Toyota Prius – is only about 4 per cent of auto sales. And the market for plug-in electric cars is actually declining. Low oil prices could well keep a tight lid on e-car and hybrid sales as the cost of a fill-up goes from extortionate to a price of a bad family meal.
Busting national budgets.
OPEC has 12 member states and most of them need prices far higher than $70 a barrel to clear their budgets. While some, such as Saudi Arabia, theoretically have the financial flexibility and health (such as low debt-to-GDP ratios and high foreign reserves) to withstand low prices for years, more than a few do not. If low prices persist, they will reach their pain thresholds and demand production cuts to prop up the price.
According to the International Monetary Fund, Deutsche Bank and other sources, At least nine OPEC members need prices north of $75 a barrel to balance their books. The ones that require the highest prices are Iran (about $140), Venezuela, Nigeria and Algeria (about $120 each) and Ecuador (about $117). Saudi Arabia requires $95 oil. Kuwait, United Arab Emirates and Qatar should feel no pain at the current price, which is not to say they like the current price.