4+1 Reasons Why Oil Must Rise, Here’s Why:

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In a short span of 2 years, the black gold, which has been averaging around US$100 between 2011-2014, has plummeted to current levels of US$37.89 (-67%) due to OPEC’s unwillingness to cap production, flooding the world with cheap oil. I’m neither an expert in oil nor an economist but based on my little research thus far, here are the top 5 reasons why I believe that oil must rise:

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1. Prices are already near or below cost of production in non-OPEC countries

In the article by CNNMoney , What it costs to produce a barrel of oil, it details the cost to pump a barrel of oil in 20 biggest oil-producing nations. As you can see, at current prices, most of the non-OPEC countries (60% market share) are either losing money or barely breaking even by staying in business. So if prices do not rise comfortably above cost of production in non-OPEC countries, production will eventually halt as businesses burn through their cash and fold-up.

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2. Low prices causes reduction in CAPEX for E&P

As the saying goes, “the cure for low prices is low prices”. At currently prices, there is little to no incentive for companies to invest in Capital Expenditure (CAPEX) for the Exploration & Production (E&P) of oil. The chart above shows the US Oil Rig Count where the number of drilling rigs actively exploring for or developing oil or natural gas in the United States.

As you can see, the number of US Oil Rigs plummeted together with the prices in oil. This underinvestment in E&P will eventually set the stage for a spike in oil prices once current oil wells begin to deplete. Furthermore, it takes several years between the discovery of an oil field and initial production from that field.

Time is needed for activities such as permitting, leasing, collection of data, drilling exploration & development wells, building surface infrastructure and pipeline, etc. Hence, supply may not be readily available even if oil prices are high enough to make a profit.

 

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Orange: Value of oil production as a % of GDP

Black: Government expenditure as a % of GDP

Red: Government revenue as a % of GDP

 

3. Low prices hurt OPEC too

Whatever the reason given for the current oil crisis, be it regaining global market share, destroying the American shale oil industry, liaison with the US to cripple the Russian economy, all of it doesn’t really matter. What matters is this, low oil prices hurt OPEC members ALOT. Oil plays a significant role in the members’ economy and budget requirements.

For example, Saudi Arabia, the most influential of OPEC’s 12 member countries, needs oil at $106 a barrel in order to break even after the costs of its generous welfare programs and energy subsidies. So OPEC can either reunite to cap production; or continue flooding the markets with their cheap oil, burn through their cash reserves, and sell/privatize their oil assets. The latter may buy them some time but they will eventually have to cut spending on their welfare programs and subsidies which will surely cause social unrest.

Just take a look at history and see what social unrest did to oil prices over the past 40 years. So both paths lead to the same destination, which is higher oil prices, the only difference is the time it would take to get there.

 

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4. Low prices increases demand for Oil

There was a Straits Times article published on 3 Aug 2015 that announced reductions in bus, train fares by up to 1.9% from December due to reduced fuel costs. Air travel has also become cheaper due to lower oil prices.

What does this mean to us consumers? It simply means that we will travel more and consume/demand more energy. Businesses (except Oil companies) will also benefit by cost savings (transportation, utilities, etc) which improves profitability. So from the macro perspective, cheap oil is good for the global economy’s growth which in turn will demand more of the black gold.

Cheap oil also reduces the appeal and incentive for the use and investment in clean energy (solar, hydro, wind, etc) which are still not as efficient as the former.

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5. The Short Squeeze Of The Decade

The 4 points mentioned above are generally understood by the investment community, the research done is fairly simple and straightforward, the statistics and facts are readily available to anyone with a computer and access to the internet.

The last point however, is mostly based on my own opinion and understanding as to how the big boys intend to play this game. So it’s purely speculation, but not without valid reasons.

Here’s what I think will play out chronologically:

  • OPEC’s goal is to force out competition, regain market share and pricing power
  • OPEC planned for this entire crisis behind closed doors, they collectively have an understanding what price to push it to and what price to push it back up
  • OPEC were the first to start shorting oil, making them relatively immune to the oil crisis, while non-OPEC countries suffer
  • OPEC met physically in public view, and instead of agreeing to cap production as expected, they gave the entire world the “impression” that talks have broken down between the members and that oil will remain lower for longer.
  • Quoting Joker from the Dark Knight : Nobody panics when things go “according to plan.” Even if the plan is horrifying! If, tomorrow, I tell the press that, like, a gang banger will get shot, or a truckload of soldiers will be blown up, nobody panics, because it’s all “part of the plan”. But when I say that one little old mayor will die, well then everyone loses their minds!
  • When everyone is convinced that oil prices will never ever regain its glory days, guess what?
  • OPEC will begin to cover their short positions, making them billions
  • OPEC will gather for an “emergency” meeting to agree to reunite for the sake of the stability of global economy
  • A OPEC member proposes a bill (already crafted in the beginning), which is readily accepted by the rest of OPEC.
  • Oil prices soar
  • Everyone else cover their short positions
  • Oil prices soar even further
  • OPEC accomplishes its goal of forcing out competition, regaining market share and pricing power.

This sort of “arrangement” has happened many times before throughout history, so this is not some sort of conspiracy theory. For example, we all know about the US Federal Reserve Bank. But do you know that the Fed was created, not by the government, but by the richest men in the US during the 1910s in secrecy at Jekyll Island? Did you also know that the Fed has shareholders whom it pays 6% dividends to?

I highly recommend this documentary on the US Fed.

As Winston Churchill once said: “The farther back you can look, the farther forward you are likely to see”.

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The Bottomline

Whenever there’s a crisis, there is an opportunity. Opportunities like these don’t come very often, about once every decade.  Success is when opportunity meets preparation. That is how it has been and will always be. Perhaps now is the time to be greedy while everyone else is fearful.

Kenny Chia

Undergraduate, SMU

2 thoughts on “4+1 Reasons Why Oil Must Rise, Here’s Why:

  • December 25, 2015 at 10:22 PM
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    Hi Kenny,

    Thanks for the reasoning and I am nodding as I read on.

    While nobody can accurately predicts oil price, it’s really commendable to have sensible logic to back where it will head next.

    I worked in this industry and most believed it will eventually go up. The question is when?

    Reply
    • December 26, 2015 at 12:52 AM
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      Hi Rolf,

      Thank you for you kind words, I really appreciate it! It’s great to know that there are readers like yourself that enjoy reading the article!

      Thats the million dollar question! “When will it happen?”. Nonetheless, we should be prepared and well positioned to profit from this crisis, it’s always better to be years early, than a day too late!

      Reply

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