Author’s Note: Originally written as a letter on 12/29/2014, somehow still relevant.
The plummeting price of oil has become a major topic of conversation – and with prices that feel more like 2005 than 2015 – no wonder. How has oil gotten so cheap, and is it too cheap?
Before we get into the why, how, and where next, let’s address a myth: America is not a net oil exporter. There are lots of ways to twist the numbers, but when it comes down to it, we import about 9 million barrels a day and export about 4 million.[i] We are also net importers of natural gas.[ii] Dispelling this myth is key; because while we have been the largest producer of oil this year, we are not totally insulated from the rest of the world.
Back to, “How has oil gotten so cheap?” In his most recent memo, Howard Marks astutely describes how high oil prices tend to lead to lower oil prices and vice-versa.[iii] The cliff notes version is: Supply and demand. The question is then, is the price too low?
While figures for the rest of the world are harder to interpret, less audited, and have the ultimate wildcards – OPEC and Russia – involved, we can look to America’s own figures for a baseline.
Per figures cited by the IMF,[iv] the current breakeven price (i.e., the price below which production is not profitable) for shale drilling in the US is between $40 and $80 per barrel. About half of North American shale production is profitable at a price of $50. The break-even price for shale is important because shale wells represent about 95% of new wells being drilled in the US today.[v]
Asking, “Is $60 the right price for oil?” is the wrong question. The right question is, “Is $60 the wrong price?” Looking into our own back yard, it looks like $60 is not the wrong price; most wells will continue to produce at $60. However, when we look abroad, we see increased levels of economic and geopolitical risk; we also see rapidly industrializing countries with billions of people. These factors, among many others, help explain why $80 or $100 oil isn’t the wrong price either.
While $60 oil seems to be on the low end of sustainable prices, the more people who think that oil is bound to go up, the more likely it is to stay flat. This phenomenon was described best by Yogi Berra, talking about a restaurant he used to frequent in St. Louis, “Nobody goes there anymore, it’s too crowded.”
Nobody has a crystal ball to know where the price of oil is headed, but I do know that following the crowd comes with the danger of being trampled by it.
[i] http://www.eia.gov/dnav/pet/pet_move_wkly_dc_NUS-Z00_mbblpd_w.htm
[ii] http://www.eia.gov/naturalgas/importsexports/annual/#tabs-supply-1
[iii] http://www.oaktreecapital.com/MemoTree/The%20Lessons%20Of%20Oil.pdf
[iv] http://blog-imfdirect.imf.org/2014/12/22/seven-questions-about-the-recent-oil-price-slump/
[v] http://energy.gov/sites/prod/files/2013/04/f0/how_is_shale_gas_produced.pdf