JITTERY OIL MARKETS. WHERE DO PRICES GO?

I can'd decide.  My auto lease is up.  Do I go with a gas guzzler, a hybrid, or a plug in?  The way the oil and gasoline market is going, it is hard for a consumer to decide.

Bloomberg News published an informative  article (OPEC Keeps Focus on Shale Threat) and interesting graph yesterday (May 19, 2017 ) that may explain a good part of why the oil and gasoline market is so unstable.  According to them....the primary factor is the new US-developed technology--FRACKING of shale rock by hydraulic pressure, sand,  and chemicals to extract dispersed oil from semipermeable sedimentary rocks like shale.  

World oil prices dropped precipitously last year---bringing the price of a barrel of oil down to about the twenty dollars a barrel range.  That  gave the big producers of oil the jitters.

But the Organization of Petroleum Exporting Countries ( OPEC) cartel is no longer the only world producer.  The massive growth of a technology developed in the USA and known as 'Fracking" or the hydraulic fracturing of oil bearing rocks most commonly oil bearing shale rock found deep underground  has made the US ((and the states of Texas and Wyoming) a big player too. In this process wells are drilled into rocks below the surface which  have their pore spaces filled with oil but the oil is trapped and can not flow as it might in more porous rock like a sandstone.  These widely distributed shales are known as "oil shales".  Wells are drilled into the oil shales---often the driller turns the well pipe to drill horizontally to penetrate the oil bearing rock over long distances.  Then, water, sand, and chemicals are forced down the pipe, under very high pressure to fracture the shales, and release the oil into the (often) heated chemically laced water.  The sand in the mixture is used to prop open the fine fractures generated by the water pressure.  Then, the oil and water are forced to the surface where the oil is separated from the water and chemicals used to extract it.  It is a messy and costly process, generating environmental impacts on the surface and to the water table.  It uses a great deal of fresh water...that is then pumped down into the ground.  But it does produce oil.   In fact, the US is now producing about one- fourth of the total world product mostly from the new technology.

So back in January 2016 while OPEC was producing about 33 m bbl per day,  the US oil industry's shale oil production efforts by "fracking" was generating a bit more than 9.2 m bbl/day, or about 22% of the total production.  The total world oil production (OPEC and other world producers plus the fracking oil from the USA)  was more than the world could use at the time.  Thus an "oil glut" ensued, and oil prices tumbled.  The OPEC producers, wary of the market share they were losing to the oil shale industry in the US, decided NOT TO REDUCE  production ( a frequently used ploy used to buoy up prices) as they have done on many occasions in the past. Instead they kept production steady as prices fell.  Since their production costs were much lower, they hoped to squeeze investment out of the US shale oil market where production costs are nearly three times what the Saudi costs are.

The financial squeeze did work.  When the prices fell  many US entrepreneurs decided that shale oil wells were not such a hot bargain. Others cut back their present investment in shale oil stocks.  Although the numerous small producers in the west who had started drilling,  or who were operating new wells (with big overhead costs) simply continued to pump and sell oil at a loss, because the option of closing down would simply cost them more that continued pumping.  The result was that shale oil production did fall off when the prices were very low--but not to zero.  By early July 2016, production of US shale oil fell off to only about 8.5 m bbl per day.--a drop of nearly 800,000 bbl per day.  US shale oil production remained at about that level to about October of 2016 when in the face of low prices, but an uptick in some parts of the world economy, production began to rise again.  In a seven month period from October to April (2017) production of shale oil increased by almost one million barrels per day from about 8.4. mbbl per day to about 9.4 MLB per day, returning to nearly its original level.  That triggered a drop in price again.

The ploy by OPEC to squeeze the US shale oil producers out of business has not worked--completely.  The total production is still down in the shale oil basins in western USA.  But it is certainly not dead.

There are two factors at work here.  The long established and well-placed oil producers can still make a good profit even on oil selling at very low price levels.  In fact Saudi oil is the cheapest to get to market.  Saudi oil costs a few cents less than $9.00 per barrel to produce and get to market. (Think of the money that rolls in to Saudi coffers when barrel prices are up to $100 dollars each).  Iran and Iraq are a close second and third respectively, with production costs at about $9 and $10 dollars a barrel.  While Russia's oil costs are next lowest, at about $19 dollars a barrel.  

But let's look at why the worlds largest and cheapest producer, Saudi Arabia's oil is so cheap.  They sit over a huge pool or underground oil ( as does Iran and Iraq).  They have paid off all their initial investment costs many years ago.  New and replacement-well drilling costs are low.  A big advantage is that- as a sovereign state who controls the oil--they pay no taxes on their product.   Their wells are mostly all in place, merrily pumping premium high grade oil.  Some wells continue to flow under pressure pushing oil through well pipes from deep underground.  On these wells there are even no pumping costs.  Their transportation and other infrastructure is in place. They are well positioned geographically to supply oil to major importers. As a result,  they can make a profit even when oil is pegged at say 20 dollars a barrel when they are make a 100% profit.

Not so with other producers, who have big extraction costs, or must extract low grade oil from tar sands like Canada,  or must use vast quantities of water, power and chemicals to fracture shales like a good portion of the US production.  So these extraction businesses are dependent on high prices to continue to keep their enterprises profitable.  The USA can not just pump pump pump...at any cost.  World conditions set the oil price and economic forces decide is it profitable or not to pump oil.  When it costs a company $27 dollars a barrel to produce and a barrel sells for only. $22 dollars...oil wells close down.

So the world remains at present---unbelievably--with surfeit of oil.  We now have after all these years of production enough oil to run all our cars, trucks, trains, boats, airplanes and earth moving machinery...and when those elements are not running so much we have a potential oil glut.  When the world economy heats up...China and the USA and the EU are major players--they demand more oil and the prices climb.  But when there is a downturn, the prices will fall.  That sounds like it may  be not so bad.. for consumers.

So this week some time the OPEC producers will gather and decide how much they will produce.  Will they keep up production and try to squeeze US shale oil producers or will they simply take their 100% profit on their cheap oil and be happy?

We will soon see.