In the upper Midwest and Plains States, oil plays a large role in the economy. It certainly changed sleepy little towns in North Dakota that had not seen significant economic growth for decades into expanding communities with new businesses, houses, and public facilities. And then, after several years of crazy expansion, growth slowed significantly with drops in oil prices that started in late 2015.
The economy of the area has since then cooled from the red hot growth of the past few years and has struggled in some areas to find a new normal. Not only has a decline in oil prices hit, but also lower commodity prices and a low Canadian Dollar has also impacted area demand. These can mislead the analyst.
Commodity driven markets can create struggles for the lender in trying to find what is normal. Often, one who is looking at a company or an area, will attempt to think to the extremes. When prices are high, there is a temptation to believe that the high prices will last forever. We certainly saw this in the farm economy from 2010-2013 where producers added more debt with the assumption the high commodity prices would continue their contango. On the other side, when prices are low, fear can make one believe that the area will only grow worse and worse. The extremes can cause you to not understand where reality is.
Now absent an accurate crystal ball, any explanation of future prices is merely a guess. However, it is possible to look at the history and present factors in the market and find some facts. The first is that oil prices have climbed nearly 80% since the low in February 2016. What is also important is that the low dips in the market have consistently been higher than the earlier lows since this winter.
The low prices have not only hurt U.S. producers, they have also cut deeply into the revenue of all OPEC producers and major non-OPEC producers. Venezuela has been an abysmal failure with the low oil prices and the socialist government. Saudi Arabia has sold nearly 30% of foreign assets in an attempt to try to balance its budget. As a major producer, Russia has experienced severe headwinds to their economy from drops in oil.
OPEC announced this past week that they were going to begin to cap production. Instantly, U.S. oil prices shot up 6%. But as with all things, the devil is in the details. OPEC had to move to change from increasing market share to capping production to halt an increasing financial mess. Increasing prices indicate the market thinks there will be a balance between expected supply and demand. This happens even though there has been a current glut in oil supply worldwide.
The projected cap for OPEC will limit production between 32-33 million barrels a day. This would put OPEN production at a level that cannot be sustained over any moderate period of time without significantly damaging oil fields and future revenue flow in many companies. The first challenge to the cap is dividing it among the member countries.
This will be a problem with Iran and Iraq, who have not had a monthly production quote for years. In the OPEC meeting in early April, Iran did not even attend the meeting. Last week they did, indicating they are moving toward agreeing to production limits.
Once the OPEC countries are all on board with production caps, a group of non-OPEC producers, led by Russia, would have to curb their output to do their part to stabilize oil prices. Russia is producing around 11.5 million barrels a day. But most of Russia’s fields are mature and are questionable if this level of output can be sustained far into the future. Moscow has indicated they would support the proposed OPEC caps as proposed in the last two cartel meetings. At this time, it is hard to tell if Russia will decide to limit production or just pay lip service to OPEC’s attempt to curb production. So watch for strong negotiations between Russian and OPEC this fall.
The next hurdle that OPEC has in raising oil prices is the volume from U.S. producers. The bulk of shale and tight oil reserves are right here in the U.S., but, unlike other major oil countries, the U.S. has no national oil company or centrally controlled oil production. So, the U.S. government cannot commit to a national position on oil production. The impact the U.S. has on global oil prices is primarily on crude import levels. It is only recently, that American drillers have been allowed to export oil. Any supply of American oil on the world market will take time before it is felt. OPEC wants to raise prices to a level that keeps American shale producers sitting on the sidelines.
The election could play a role here as there is one of the presidential candidates has indicated a commitment to U.S. energy independence. This would use whatever resources we have here in the U.S. to keep us from imports. Also, some local oil regions have recently experienced more opposition to fracking. Oklahoma has seen a rise in earthquakes that some believe is a direct result from fracking.
The other factor is that innovations in technology have driven down the up-front cost of shale wells. So now these producers can be profitable at lower levels of oil prices. There are also large numbers of partially completed wells that are not producing. Completion of those wells will be at an even still lower cost. In North Dakota alone, there are over 1,900 partially completed wells.
So take all these factors together, thrown in a wild card of any major political instability in oil producing countries like Venezuela or Nigeria, add some overall growth headwinds to global economic growth, and the crystal ball begins to get pretty murky. Overall my guess is we will see prices continue to rise gradually but not reach the high levels we saw a few years ago. This will bring production back to U.S. shale producer, but not at the same torrid pace we saw a few years ago.