The masses of oil bulls continue to value companies such as Oklahoma’s Continental Resources using models that assume $50 dollars per barrel of oil this year, and up to $75 next year.  There is no reason to bet on this.  Not only might oil prices go significantly lower, there is no reason to believe that low prices won’t last for a long time.

What exactly this means for Oklahoma’s oil companies is the subject of another post, but in short it will be a massacre for most, with only Devon emerging in a decent position.

Reason 1:

The first argument against oil prices staying low is that the reduced price will cause rigs to shut down and therefore the supply to decrease. That is true at some level, but:

As pointed out recently by Bloomberg “The CHART OF THE DAY shows how West Texas Intermediate, the U.S. oil benchmark, tumbled 69 percent from $31.82 a barrel in November 1985 to $9.75 in April 1986 when Saudi Arabia, tiring of cutting output to support prices, flooded the market. Prices didn’t claw back the losses until 1990. ”

oil-chart

If the current decline in prices did not result in a quick rebound in 1986, why is everyone so sure it will now?

More importantly, as the price declines oil companies might slow drilling, but they actually have every incentive to pump as much oil as possible in the short-term – and that is exactly what is happening:

As pointed out by The Daily Oklahoman

The U.S. Energy Information Administration this week said domestic production is likely to increase throughout this year and into next, and will approach record production levels in 2016.

Analysts like to point out that the price of oil is below the per-barrel production costs in many areas. However, suggesting that this means there will be a decrease in production ignores basic economics. Sunk costs are not factored into current production. The money spent to drill a well has already been spent. Oil will be pumped until the price falls below marginal production costs, not total production costs. With prices down and balance sheets under pressure, oil companies will make sure that existing wells maximize production rather than minimize it.

This same analysis applies to countries such as Russia and Venezuela which will also pump as much as possible for the time being.

The hope exists that Saudi Arabia will cut production, but there is no reason why the lowest cost producer will cut production before the high cost producers do. This would be like expecting Dell to cut production in order to raise prices: The world just doesn’t work that way.

Production will continue at a high rate for a significant amount of time.

We see this today as production continues to rise

Reason 2:

Those focused on supply and demand tend not to talk about financial players in the oil industry. If you want to have a discussion about why oil prices are going down then at some point you need to have a discussion about why they went up to begin with. The “standard” analysis says that oil prices have gone up as “peak oil” combined with rising demand from China and other developing nations to push oil prices through the roof. However, that is not the entire story.

Once upon a time, for well over 50 years, non-physical participants were subject to position limits in commodities markets. Speculators are needed in commodities markets but the government limited their participation to assure that they didn’t dominate commodity markets. This worked well for a long time. In the 1990’s, however, these limits were done away with in a secret manner. In 1991, J. Aron (owned by Goldman Sachs) wrote a letter to the Commodities Futures Trading Commission asking that it’s speculative hedging be treated as a “physical hedge”, the theory being that just as a farmer is hedging a real risk, so were they hedging a real financial risk. The CFTC agreed, and this was the beginning of the end for position limits. These letters were quietly and without public comment issued to more and more speculators and by 2008 at least 80% of all commodities market activity was being done by neither producers nor suppliers. These letters were issues in secret and it was almost by accident that a congressional staffer overhead an offhand remark about them and then pressured the CFTC for their release.

What did these banks do with their secret letters? They created index speculation among other things. The most prominent of these were the Goldman Sachs Commodity Index (GSCI) and the Dow Jones-AIG commodity Index.

These served the basis of a huge influx of pension and trust money into the long only side of the commodities markets. Simple supply and demand suggests that a massive surge in demand of a commodity is going to increase the price of it. As opposed to the traditional speculator supplying liquidity to the market, the GSCI is essentially hoarding commodities, as it is a long only index.

As reported by Matt Taibbi in Griftopia from 2003 until July 2008, the amount of money invested in commodity indices rose from $13 billion to $317 billion. Not surprisingly the prices of all twenty-five commodities listed on the GSCI rose sharply.

In short, commodity prices in this day and age may, in the long run, depend on the supply and demand of the end suppliers and users, but in the middle Wall Street, with its free money from the Fed, drives price movements.

So, all of those citing the supply and demand are not really saying anything about the short and medium term if they are not accounting for financial flows into the oil business. And just what is going on at the moment?

Due to the Fed’s fear of deflation interest rates have been near zero for some time – this punishes savers, including pension funds. In a never-ending search for yield Special Purpose Vehicles have been created to conduct cash and carry trades in commodities in contango as oil normally is. In the cash and carry trade oil is bought and stored at spot, with the futures sold forward. As the trade nears its end the rise in the price of the spot covers the short futures obligation. If leveraged this trade can provide a nice return that a pension fund otherwise can’t get- and leverage has been easy in these days during the periods of Quantitative Easing. A friend who sees a lot more deal flow than I do tells me:

“Over the past few years oil production has been estimated to have exceeded demand by 2 mil bbls/day. Much of this excess supply was absorbed by governments adding to their strategic reserves and investor buying into these structured c/c trades. The structured c/c trades often involved baskets of commodities (e.g., oil, gold, copper). They were bundled into Special Purpose Vehicles The buyers were anyone looking for a bond-like rate of return notably pension funds or hedge funds who bought these packages for their pension investors.”

Now that the appetite is gone, US oil production has increased and OPEC has decided not to cut production oil prices have declined rapidly.

The really big questions are how were the SPV’s financed? Are they marked to market? Are the susceptible to margin calls? And then there is the question of why the banks wanted to revise Dodd Frank to let them hold on the Collateralized Loan Obligations for a few more years???”

Those are good questions. I don’t claim to know exactly what is going on, but I do know that the oil price collapse happened with the end of QE, suggesting that many of these trades have imploded and their spot oil is being dumped on the market. If one doesn’t understand how many of these deals are out there than one has no business predicting the end of the decline in prices.