The price to kill unconventional oil

11:47 PM Posted by Baris Sanli

The oil prices have seen the biggest decline in years. There are lots of analyses and discussions to reachto the undercurrents. But one important element of energy markets is,you shall not stuck to the present but to speculate on the future developments and position yourself accordingly.

Oil prices themselves can not be modelled for long time. IEA’s projections are the witnesses. They do not model oil prices but simply assume the pathway to the future. The human mind can not gather all dynamics to pursue a forecast for oil prices. They are basically –due to our incapacity- random walk for now.

Take the brent price for example… Who do you think can guess the prices better? A trader or a monkey. If you choose  traders, as I have done before, you are dead wrong. Until July very very few predicted the prices will go down, all majors predicting high prices. Why? Let’s look at forecasting the best portfolio for investment.

When it comes to select the portfolios for investment, economist Burton Malkiel claims “a blind folded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts”(1) in his “A Random Walk Down Wall Street”. Oil prices are not very different. A monkey can do better. Even if you reject to make a calculation and just spell the price of today, theoretically you will be more succesful than the best predictor.

Or from another perspective, prices are created by the interaction of so many events , Chaos theory’s famous butterfly-stormexample is well suited for the oil prices. But neverthless we can extremely simplify everything and try to find our way out of this mess..

Let’s focus on unconventional oil. We can easily assume that prices are not predictable. Because there is a two way interaction, prices create or destroy oil production and oil production deflates or inflates  prices.But it doesn’t end there. The level and duration of prices are extremely important.

If the prices stay low for a limited period of time, consumers do not relax and scrap the efficiency gains from the “high price era”. But if this limited time prolongs, the consumers skip the lessons from the wild era of oil price peaks and go back to driving SUVs. And here is the proof from November 2014.

According to Bloomberg, US car sales increase 4.6% in November 2014. Toyota Prius sales were down 14%. Car sales up 1.2%. SUVs and crossover utility vehicles rose 12%.Despite being more efficient than 4 years agos, SUVs are heavyweights of oil consumption.

This latest statistics shows that oil prices can not stay low for so long. Assuming that China and EU, US will not fall into recession.

If prices can not stay low for so long, what is the balancing price? So far, below 80 $ for brent is a positive sign for demand increase. The statistics confirm that. People got used to 100$s and anything around 80$s is a flag for more consumption. It is like drinking water after eating lemon.

But prices are still decreasing as of December 2014? Yes because the dynamics are also distorted by some other behavioral factors. The battle for the market share!

Kingdom of Saudi Arabia(KSA)’s price discounts  to US and Asian markets are an indication of such a war. It is not economics but sentiments.. KSA feels threatened by the long term (not short term) structural changes in the market. It has the guts to lower the prices to preserve its position in its major markets for the endless battle to kill shale oil.

But what is the price level to kill shale oil?


 

EIA’s director Adam Sieminski has an excellent answer for such discussions. The price vs production graph for US unconventional oil explains it all. It says “above 70$, more will come”. Between 50 and 60$, there are few reasons to be bullish.

KSA can practically drop the prices to 30$ and even 20$ for a limited period of time. But the production may not stop there. To understand why, we need to clarify terminology.

According to Professor Paul Stevens from Chatham house, we have to make a distinction between break-even and shut in prices:

  • “Break-even price: what investors consider when deciding whether to invest in new production capacity”
  • “Shut-in price: what existing operators consider will cover variable costs if not, will stop production from existing wells.”

Let me clarify the logic behind these terms. Assume that you opened a restaurant and spent 50000$s for decoration, construction, marketing etc..  To survive you assumed a 1000$ turnover everyday. On Monday, Tuesday and Wednesday, the turnover was terrible and you hardly made 700$. Everyday, you have to spent 500$ for meat, vegetables etc and workers. 1000$ is your break-even price, 500$ is your shut-in price.

You simply do not shut down your restaurant because of the short term results. But if you can not even earn 400-500$s, that’s the trouble. Even if you make less than 1000$, you may continue the operation for another 3 months with improvements. With less than 500$, dead in a matter of weeks.

Oil wells are alike. Once you made the investment, break-even price is not enough to kill your investment. Actually the killer price is much much lower than break-even price, it is the shut-in price. Your bank can reorganize your payments for some time, but 2 weeks of non payment to workers may stop your operation.

Prof Stevens claims, the shut-in price for shale is below 40$s. As he claims this is debatable…

Can 40$s kill shale oil? It depends on the duration of low prices. 6 months – 1 year with prices below 40$? No…

No it should be long enough to persuade consumer that prices will stay low for a long time and he should increase his consumption. Practically, if anyone with a Prius changes his mind for a Hummer, that is a sign. And this will ignite another cycle of demand growth to fuel prices.

So not only price but the persistance of this price will define partly the fate of shale oil. As the prices are not predictable, it has to persuade!

What ever it is, oil prices are not only a bunch of numbers, but numbers that turn the mills of economy and consumer behavior, a sign of health, a multi dimensional vector summed up in 2 or 3 digits. It is not only the level of digits that will kill shale oil but the other dimensions.

To persuade, the discounts shall continue, they had to persuade consumers and “traders”, if the recent move aims to kill shale. That is why prices may collapse in the short term, because it is race to the bottom as well as race to the nowhere for producers.

 


 

 

 

 

 


 

 
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