Oil prices are falling as a combination of oversupply and demand destruction.
North American non-conventional oil (tight shale and syncrude) has added the only new oil production growth the world has seen in the last ten years or so. The oil produced, however, is very expensive, with most costs being up-front. As a result, most of these operations have been cash-flow negative and have large debt loads.
In terms of demand, most new demand was coming from Asia. Last year, it became apparent that various economies, particularly the massive Chinese economy, was not growing as fast as anticipated. This meant that there wasn’t a growing market for oil.
In the past, this would have meant that producers would slow down production and wait for higher prices. However, due to the high debt loads and sunk costs of North American non-conventional oil, they’ve had to keep pumping and selling oil, no matter what the price of oil.
Some expected that, in response to the falling price of oil last year, Saudi Arabia would cut production to keep prices up. However, while Saudi Arabia is swing producer to OPEC, the cuts they would have to make in this case would have to be huge. As they tried this once before (’80-85) and it ended in disaster for them, they’re reluctant to do it again.
So the Saudis approached several other major non-OPEC producers (particularly Russia) and tried to hammer out a deal to share cuts in order to keep the price up. The other producers refused to make cuts.
So Saudi Arabia also refused to make cuts. They didn’t want to take a massive financial hit to support Russian and US higher-priced oil. They’ve repeatedly offered to make shared cuts, but so far no one has taken them up on that offer.
So now it’s a waiting game. All producers, including Saudi Arabia, want higher prices, but a deal can’t be made. Russia is artificially supporting production below cost, US and Canadian non-conventional oil is being sold at a loss because they have to or go bankrupt, and Saudi Arabia, while still making money at these prices, is having to borrow money to balance their economy’s budget.
What will eventually happen is that production somewhere will fall, and supply will get smaller. Whether the price will go up again is another matter, as that depends on world economic growth, which seems to be ever-slowing.
In terms of why they’re falling further now, more bad news from the Chinese economy means lower demand for oil. And lower demand for nearly all major commodities, whose price is also falling.
Posted by stumo
Thank you so much for the explanation. If you don’t mind, I have a couple more questions. Why is the oil North America produces more expensive?
If the costs are up-front, leaving them cash-flow negative, why would the other non-OPEC producers not agree to the shared cuts? This seems like a reasonable reaction to the low demand…
One last question, which if there is a source you can point me to because I know its a big question and I don’t want to take too much of your time..What drives world economic growth and why is it slowing?
Posted by BadKittie83
Why is the oil North America produces more expensive?
It’s just the non-conventional oil that’s more expensive because it takes a lot of industrial effort to extract. Canadian syncrude is made by heating mostly mined bitumen (which is asphalt-like), and that requires a lot of energy. Tight shale is like regular drilling, but requires an energy-intensive hydraulic fracturing process, which adds about 50% to the cost of production. And unlike conventional oil wells, tight shale well production drops very quickly to a fraction of the original output.
If the costs are up-front, leaving them cash-flow negative, why would the other non-OPEC producers not agree to the shared cuts?
Beats me. Perhaps the Russians thought that the Saudis would cut production regardless. I doubt that North American oil was approached because they’re a bunch of independents rather than a nationalized oil company.
What drives world economic growth and why is it slowing?
If you ask two economists that, you’ll get three different answers. I’m not an economist, but my own view is that the consumption of conventional oil plays a huge role in economic growth. Conventional oil production stopped growing ten years ago, and so expensive non-conventional oil was tapped. I think that because of the extra costs in producing and using this type of oil, it generates far less economic wealth, if any at all.
If that’s the case, then global economic growth has slowed due to flat production levels of conventional oil.
which if there is a source you can point me to
The best source I can think of to support the above theory is Gail Tverberg.
Posted by stumo