By Keith Reid
Prices are plunging, from crude to the products that are refined from it. We touched on some of the reasons in the last price outlook we had before the heating season got underway, and were going to expand on that somewhat as the trend keeps continuing. Our two industry experts being consulted are Alan Levine, CEO and chairman of Powerhouse®, which provides hedging and price risk management services; and Brian Milne, the editor of Schneider Electric’s MarketWire, a real-time market and news service focused on U.S. oil product markets. It should be noted that these interviews were conducted late December through early January. Prices are very dynamic at this point of time (though more so in a downhill collapse type of way) and it’s not inconceivable that a significant shift could have occurred by the time you’re reading this article.
“What we’re seeing right now is that we’re in a price war,” Milne said. “It’s not being called that, but the expectation was when prices got this low you would see a lot more production shut in and that is not happened. In fact, there are indications that that this is going to be the way it is. There are fewer wells being drilled, but there is a lot of production out there and [OPEC] realizes that somebody has to shut in production but whoever doesn’t shut in production will be better off.”
To a great extent, what is happening is being looked at as somewhat of a miscalculation by Saudi Arabia. The speculation is that there was a lack of real intelligence as to the actual production costs through fracking technology, as well as overlooking some of the financial drivers that would maintain production in the face of cost factors.
“The thing that made the difference was the Saudis, who ordinarily would have reduced their output as a way to support the market, decided that was not going to fly anymore,” Levine said. “So as a result of that they decided to hold up to their production schedules, and effectively try to reduce output by competitors in particular the United States. And so far that plan hasn’t worked out very well.”
Levine noted that there are basically two time frames to be aware of with these developments—current and future production.
With the current productive capacity from existing wells, the price point for profitable production has seemingly been far lower than anticipated. “We went from $90 to $80 to $60 per barrel and now the question is—where is the point at which we stop producing?” Levine said. “While I’m certainly not an engineer, some of the stories that are coming out have stated that in places like North Dakota there are some wells that can produce profitably as low as $28 per barrel. It’s not like overseas where the central government is controlling the oil industry—you have hundreds of producers and you’re not going to tell them what to do. Each has their own economics.”
And part of that economic equation is related to production loans of one kind or another, noted Levine. “The producers have to service the loan—if they do nothing else—and they can’t service it if they are not producing. So I think the likelihood of a serious slowdown in domestic production is limited, at least with the present equipment in place.”
“I think [the Saudis and others] missed that there have been a lot of sunk costs already by producers such as renting railcars and pipeline space,” Milne said. “Those costs are already in the contract for a couple of months. And it’s going to take a while longer because of that for lower prices to have a bigger hit on reducing U.S. production. Were still at over 9.1 million barrels of production and the expectation is that we still haven’t seen the high. Production is going to keep growing in the first quarter, and then at some point will reach a high and it’ll start to taper off.”
The second time frame encompasses future exploration and production beyond wells that are currently on line. Both Milne and Levine noted that this activity is beginning to slow. Levine noted that perhaps three years from now, when the current crop of producing assets start to slow down, you may then see the United States producing a bit less, “But even here, I don’t think we can write the epitaph of the shale revolution just yet,” he said.
Of course, U.S. production is only part of the picture of what’s going on right now. While the U.S. economy seems to be making some degree of recovery, the European economy is a disaster and there are concerns with the Asian economies. There is no doubt that the demand side of the equation is playing a significant role in our current low crude prices.
“Europe is really struggling,” said Milne. “The European central bank could make some moves to announce stimulus efforts to shock the market and stop the bleeding, and that would translate into some support for oil prices, but we will have to wait and see. And we have to wait and see what Japan is going to be doing and we’re seeing growth slow in China, especially on the industrial side. That affects oil demand big time over there, because they use a lot of diesel. You had been seeing gasoline offset some of the diesel losses in China, but it’s anticipated that that will likely start slowing because there will be more restrictions on automobiles because of pollution.”
It would also be reasonable to assume that some of the volatility and spiking behavior has been eliminated by the derivative reforms, watered-down and resisted as they might be, that the industry help push through in the Dodd-Frank legislation.
So just how low is crude likely to go in the short-term?
“We’ve looked at the market and right now and crude oil has traded at $54 [since passed],” Levine said. “When the market fell apart in 2008, which was an entirely different set of circumstances, it went to $33. It didn’t stay there very long. Here, I think we have a very different circumstance. I wouldn’t be at all surprised to see it settle somewhere below $50—maybe the high $40s—and we might anticipate staying there for some time. There would be spikes of course, but that would be likely be my guess best guess.”
“If you are looking at some of the charts alone you can get down to the low $30s—you really could,” Milne speculated. “I don’t know that we get that that this year—but we could. And that’s just on the supply side.”
As might be expected, expectations for refined product prices like heating oil and propane are broadly linked to the current exploration and production boom, and should follow a similar trajectory moving into the summer. Obviously, there are domestic supply and demand issues that seasonally impact such prices.
For heating oil, Levine stated he could see a wholesale recovery toward $2.25, or that range, around March as agriculture starts to pick up again. On the retail side, Milne sees prices short term prices of perhaps the $2.92-$3.05 range in the same period.
With propane, Levine sees wholesale prices staying around the $0.50 range and being resistant to pressure due to both current production levels and supply storage levels—particularly if there is not a spike in super cold weather.
“The U.S. average for retail propane has been around $2.36-$2.37, and it’s definitely coming down with oil,” said Milne. “But another factor which is just amazing is how much more supply we have now the new year ago. Granted there are a lot of challenges last year, but were at nearly 70% more propane which is huge.”
So far, the weather model has been more in line with the milder EIA outlook than that of other meteorologists’ forecasts this winter. But, the winter is certainly not over yet.