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Wednesday, October 22, 2014

The oil price conundrum

I think everybody accepts the idea that falling energy prices are good for the general economy.  We have recently had a 20% drop in oil prices which should be a very good thing.  However, sometimes big drops like that are associated with recessions.  In those cases it can take quite a few months before the lower price benefits are noticeable in the economy.  While we do not yet know if this drop is associated with a recession there is clear evidence it is associated with a bout of global economic weakness.  In the U.S. there is more to the problem of deciding if the price drop is good or bad.  We have seen a massive amount of drilling since the great recession and that has provided a good part of the economic strength we have seen.  I believe this is the major reason we are looking so much better then Europe.  Many credit the FED, but I believe that is incorrect.  Texas is booming and accounts for all of the increase in jobs above where we were in 2007.  All that oil money and drilling is feeding throughout the entire U.S. economy.  So what is the point?  Take a look at this chart of cost curves.

The shale oil line has a pretty high cost associated with it.  Below $85 and a lot of production gets shaky.  Below 80 and a things get really, really hairy.  Shale oil wells deplete rapidly and after 5 years produce about 20% of initial amounts.  That means many new wells need to be drilled all the time just to keep production at the same level.  Like all other new oil fields the drillers go after the easiest stuff first.  That means those later wells get less and less productive which keeps raising the break even price point.  Oil wells are usually drilled with borrowed money.  This is the exact same scenario as the oil boom and bust in Texas in the 80s.  The oil price dropped below the break even point of many of the later wells which caused massive defaults on the loans.  The current price is probably already low enough to curtail drilling of new wells.  It will be more difficult to get financing now.  That in itself will likely slow U.S. economic growth some.  Whether the low oil price is enough to offset in the rest of the economy I don't really know.  The price drop is a one time benefit.  Once price stabilizes future growth from it will stagnate.  However, the longer the price stays low the more damage will be done to those highly leveraged drillers.  Saudi Arabia appears to be quite intent on keeping price low to hurt Russia and keep U.S. oil off the world market.  This seems like a bit of a dangerous game to me.  Massive loan defaults seem to have a way of infecting the economy in unforeseen ways.  Lets look at the oil chart.

I expect right now there are lots of oil people sitting on the edge of their seats worrying and wondering about their future.  The longer the price stays in this area the worse that is going to get.   Oil is clearly oversold here at the $80 mark as it is well stretched from its 200 SMA.  However, I learned in 2008 that oil can get very, very oversold and keep on going down.  I have heard some calls for a drop down to $60.  I am positive that much of a drop would put a lot of drillers out of work.  This may end up being much ado about nothing or a major catastrophe.  It is probably too early to tell yet.  However, it clearly has bothered enough investors that many shares of oil companies were dumped in a panic.  I think this situation is worth being aware of.

Here is an interesting article about shale oil.  We're Sitting on 10 Billion Barrels of Oil! OK, Two  We have been told we have huge amounts of oil reserves.  It turns out what these companies tell investors is much different then what they tell the SEC.  I am sure the real truth is somewhere in the middle, but the discrepancy is so wide it is important exactly where in the middle it is.  Sometimes things sound too good to be true.  I don't know if this is a case of that or not, but it could be.


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