As the price of oil starts its second dramatic act of the year, collapsing after a short-lived rebound in the Spring, many investors are undoubtedly hoping that the price will start to rise again later this year.
Those hopes may be misplaced as Texas looks set to produce a record level of output this year, toppling a production record that has stood for more than thirty years. And Texas is not alone on that front. Around the world, many countries are reporting continuing or increasing production. OPEC looks to have pumped more oil in July than in June despite the fall in prices. And in the medium term, Iran’s production will exacerbate the situation.
The fundamental problem with the oil markets here is one of incentives. Oil wells require extensive up-front costs. Once those costs are spent though, the price of pumping out the oil itself is relatively low. As a result, with these sunk costs already invested, companies around the world from Saudi Arabia to North Dakota have no individual incentive to lower production.
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A single company in North Dakota for example, cannot raise the price of oil on its own by cutting production. As a result, the company instead wants to maximize production from its existing wells. It may not be economical to drill new wells, but the company might as well get full value from its existing set.
Even worse for price though, firms have an incentive to produce now rather than waiting.
Previously, some firms likely hoped that oil prices would spring back by the end of 2015 and that the firm’s hedges could keep sales receipts high enough to avoid dealing with the dramatic fall in prices.
But prices have not bounced back, and with most market participants now resigned to at least another year of low oil prices, a lot of hope has gone out of the markets.
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Moreover, summer driving season is starting to wind down, and with it, demand for oil will start to dwindle. As a result, it’s quite likely that prices in the low $40s or even high $30s will be seen by the end of the year. Faced with a classic deflationary price spiral, companies want to maximize their per barrel revenue and that means pumping as much as possible as fast as possible and selling now before prices fall more.
There are only two ways to fix this type of deflationary price spiral in economics: consolidation of the industry leading to monopoly or oligopoly power, or the exit of firms from the market.
OPEC was able to keep prices from collapsing like this for decades because the block of producers acted as a monopoly. As long as most significant producers were inside the cartel or went along with its production levels, prices could remain stable. The arrival of non-traditional producers like oil sands firms and shale oil firms upended that model. Now, the Cartel cannot exert the same level of influence on production levels, so even OPEC members have little incentive to do anything other than pump as much as they can.
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The other solution to the current oil price environment is a wide-spread exodus from the industry. In practice, this means a combination of bankruptcy, and not drilling new wells. The EIA is showing a record level of excess production over demand, and that production gap has to be corrected by firms deciding it is not in their best interest to drill new wells.
This will take time though. First, many firms were propped up by their hedging programs. Those hedges are only just now starting to expire and exposing firms to the full depth of the oil price drop. Second, firms will keep pumping in many cases until their wells run dry. Fortunately for oil investors, shale wells have a much faster decline rate than traditional wells. Shale wells decline at a rate of between 60 percent and 90 percent over the course of three years.
With the price collapse having started roughly a year ago, that means that it may take about two more years for unconventional output to actually start declining. Given that, investors need to focus on oil stocks that can get through the next two years on minimal (if any) profit, and they themselves need to be prepared to wait for a price rebound until 2017.