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DIGITAL EDITION
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THIS WEEK'S TOPIC:
CRUDE PRICES
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The fall of crude prices and the effect on OPEC's production levels
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Crude prices on Thursday bounced off of 6 1/2-year lows. Just a little over two years ago, West Texas Intermediate (WTI) crude was trading at more than $100 per barrel, and now it is trading at nearly $40 per barrel. A combination of increased U.S. crude production and the Organization of the Petroleum Exporting Countries’ (OPEC) response to that production has caused the collapse in crude values.
In 2008, U.S. crude production dropped below 4 million barrels per day (bpd). This year, U.S. Crude production peaked the week of June 5 at 9.61 million bpd. The increased production was a result of breakthroughs in processes and technology that allowed crude trapped in shale to be produced.
The process and technology to produce this crude in an unconventional method is not cheap. It requires drilling many wells, as well as heavy infrastructure development. The break-even crude price varies by fields and wells, but a price of approximately $60 per barrel was needed to justify the investment before the collapse of prices.
High demand for drilling rigs and completion services elevated the cost of drilling and operation. Still, with crude selling at more than $100 per barrel, profits were high and over 2,700 rigs were drilled for oil and gas in the U.S. and Canada a year ago, mostly in shale formations. Non-conventional production in Canada also added to supplies. The new production began the first phase in driving crude prices lower.
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Historically OPEC had been the world’s swing producer, meaning it would adjust its production to help balance the world's crude supply with demand as a way to support prices. But, based on past experience and the rate of growth in U.S. and Canadian crude production, OPEC realized lowering its production would simply mean giving up market share to other producers. Its decision to increase production caused the second phase of crude devaluation.
OPEC thought that in the short term it could use its significant production cost advantage to drive high-cost producers in the U.S. out of the market, forcing OPEC to become the world’s swing producer. At this point OPEC is winning the battle, but it may be losing the war. It has succeeded in cutting North American oil and gas drilling activity down to below 1,100 active rigs.
As a result, U.S. crude production is down about 262,000 bpd from its June peak, and that rate of decline is likely to continue. However, because drilling has slowed, costs to drill and complete wells have also dramatically dropped. It is now believed that many shale projects could break even at around $50 per barrel on average. The cost reductions have most likely allowed U.S. production to remain high for longer than OPEC anticipated.
Despite the drops in U.S. production, it is estimated that the world is still oversupplied with crude by as many as 3 million bpd. OPEC has been undaunted by such oversupply, believing that increased demand next year will balance supply and demand and cause crude prices to rise. At that point OPEC will have increased market share and make up for short-term losses. OPEC most likely deemed these short-term losses necessary to educate the world about the new crude paradigm where OPEC will be the world’s leading producer and no longer the balancer of supply and demand.
Developments in Asia, specifically China, put the higher demand assumptions of OPEC at risk. The result has been to drive crude prices far below anything necessary to accomplish the initial objective of driving high-cost producers out of the market. One has to wonder if Saudi Arabia, the mastermind of this new OPEC strategy, did not hedge a lot of its production before unveiling its new strategy, making it somewhat impervious to the extent of this oversold crude market.
Still, it would seem the concerns about demand may force OPEC to reassess its production position. It may be unrealistic to put the entire burden of oversupply on the higher cost producers. Although a few OPEC members are calling for a meeting to discuss ways to stabilize the market, there appears no real interest by Saudi Arabia to meet or consider cutting production. Without Saudi Arabia, OPEC will not make a change in production policy.
When crude falls below $50, the internal and political strife within OPEC is apparent. It appears that Gulf Arab nations such as Saudi Arabia could be more worried for political reasons, such as losing market share to Iran when its sanctions are lifted next year, than for its relationship with already-kowtowed U.S. producers.
At this point, U.S. producers may no longer be the enemy of the new OPEC strategy and have instead become collateral damage in a war of ideologies in the Middle East. Since we can’t be certain this is true, we must worry that OPEC will surprise us all with a production cut. If there is one good reason to buy propane at this point – despite fundamentals screaming that we should not – that would be it.
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WEEK IN REVIEW
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There was a major correction in crude markets last week that pulled propane prices higher. The question is whether the correction was short term and the bear market conditions will resume or if crude has turned a corner and will continue higher.
Fundamentally nothing has changed and the market shouldn’t have the foundation for a continued rally. Nonetheless, markets can trade on emotion for a stubbornly long period. We will go back to neutral to start the week and see how traders respond after a weekend to calm down and reassess.
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LAST WEEK'S HIGHLIGHTS
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An 8 percent drop in China’s stock market sent commodities and equities markets down sharply. Crude lost more than 5 percent and propane followed.
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Opportunity buying after Monday’s sell-off helped WTI regain about half of its previous day’s loss. Conway propane managed to round up enough buyers to follow crude up, but Mont Belvieu stayed unchanged from Monday’s close.
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An above-average build in U.S. propane inventory that put U.S. stockpiles over 95 million barrels sent propane prices down sharply. Crude slipped despite a surprising 5.452-million-barrel draw on U.S. crude inventory. Crude traders shrugged off the draw, blaming it on a reduction in crude imports.
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A massive move of more than 10 percent in WTI crude’s price pulled propane sharply higher. Crude rallied with equities markets supported by an upward revision in U.S. gross domestic product for the second quarter. Force majeure on crude exports from Nigeria by Shell added support. The rally was fueled by buyers that closed short positions to protect profits.
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Refinery issues on the East Coast pushed gasoline prices up sharply, helping continue the rally in crude and force more that were positioned short crude to step into the market to close positions. Propane prices were very aggressive in keeping up with the move in crude.
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CONNECT
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Cost Management Solutions LLC (CMS) is a firm dedicated to the analysis of the energy markets for the propane marketplace. Since we are not a supplier of propane, you can be assured our focus is to provide an unbiased analysis.
Contact us today to see if you can benefit from having the Energy Price Watchdog working for you.
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