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Oil Glut Sends Crude Prices Tumbling and Hammers U.S. Producers

Oil Glut Sends Crude Prices Tumbling and Hammers U.S. Producers

Oil bears are rampaging across the globe, sending crude prices tumbling to six-month lows and raising fears of a reckoning for the U.S. producers who helped create the mess in the first place.

Crude oil dropped again in early trading in London and New York, sending prices well below $50 a barrel in the United States and just over $50 in Europe, before clawing back their losses later in the session. But the months of respite for oil traders seem over: Brent crude has lost almost 20 percent in July.

At root, it’s easy to see why: The world is simply awash in the stuff, and there isn’t enough demand out there to soak up all the supply. The world has added about 3.1 million barrels a day of oil production this year, but consumers are only buying an extra 1.4 million barrels a day. Since OPEC decided last November to keep pumping regardless of lower prices, it hasn’t looked back, adding 1.5 million barrels a day of oil to markets that don’t need it. Put another way, OPEC is still pumping 2 million more barrels a day than it needs to sate global demand.

“Prices fell, [and] people thought, okay, ‘Production is going to go down.’ But the opposite has happened: Production has continued to go up,” said Jim Burkhard, head of oil market research at IHS Energy. That’s due both to OPEC’s decision to keep pumping and to the surprising resilience of U.S. oil producers, who so far this year have shrugged off the lower prices that were expected to poleax them and have continued to pump at the highest levels in 40 years.

If anything, the Iran nuclear deal threatens to make the mismatch between global supply and demand even worse. Once sanctions on Iran are lifted, the country will be free to ramp up crude exports. With sanctions in place, Iran’s oil exports were cut in half, from about 2.5 million barrels a day to around 1.1 million barrels a day in recent months. Iranian oil officials and energy analysts figure by early next year, Iran could add another 300,000 to 500,000 barrels a day to already glutted markets. That would be bad news for U.S. producers, who need higher prices to blast oil out of shale formations deep underground.

So what’s the answer? Either demand has to pick up, or supply has to cut back. And that’s where the outlook gets grim. OPEC producers show no signs of retreating from their decision last fall to throw open the spigots. And U.S. producers, who generally need higher prices than producers elsewhere because of the costs of fracturing shale formations, have learned to live with cheaper oil, for now at least. That’s due to rapid increases in efficiency among producers in shale formations, who have on average cut drilling costs by about 20 percent. For companies like Continental Resources, which operates in North Dakota’s Bakken formation, $60 oil these days is about as profitable as $80 oil was in the past. Overall, the United States is currently pumping 1 million barrels a day more than it was last summer when crude cost $115 a barrel.

“You can cut back on drilling quite a bit and not see a proportionate impact on production,” said Burkhard of IHS Energy.

Burkhard and other analysts expect that the price plunge will finally take a toll on U.S. producers in the second half of the year, when production will stop growing, though it won’t shrink. That has the industry bracing for some tough times. Oil companies and service providers are slashing investment budgets and cutting thousands of jobs; investment bank Goldman Sachs reported the oil-patch pain knocked half a point off U.S. GDP growth in the first six months of the year.

What about the other half of the equation, demand for oil? Even though oil — and refined products like gasoline and diesel — got a whole lot cheaper in the last year, that didn’t translate into a surge in consumer demand as in the past. Global demand picked up earlier this year, then fizzled, even though crude costs about half what it did this time last year.

And it doesn’t look like it’s going to come roaring back next year, either. The International Energy Agency, in its latest oil report, expects oil demand to creep up in 2016 by about 1.2 million barrels a day. OPEC is a bit more optimistic. Either way, that still won’t be enough to absorb all the extra barrels that Saudis, Iraqis, and Americans have been pumping over the last year — and any extra oil that Iran dumps onto the market. And that points to a prolonged period of lower prices — with negative implications for Middle Eastern producers heavily reliant on oil sales for their budgets, for Russia’s recession-riddled and oil-dependent economy, and even for the green shoots of healthy economic activity in places like Texas and North Dakota.

Lurking behind that gloomy outlook, just as it did when oil prices reached triple digits, is the Chinese economy. When China was growing at 10 percent a year and becoming the world’s largest auto market, Chinese demand for oil — and every other commodity — skyrocketed, helping the country surpass the United States as the biggest oil importer. But now the Chinese economy is adjusting to a new normal, with much more modest GDP growth rates and a shift away from energy-gobbling sectors to leaner activities such as services. All that means is that the wildcard of limitless Chinese demand just isn’t in the deck anymore.

“We’re not likely to see the fantastic rates of demand growth in the next ten years that we saw [before] out of China,” said Burkhard. “And there’s no other country that is capable of offsetting weaker Chinese demand growth.”

And that raises the longer-term question of just how sustainable America’s energy boom really is — not from any shortage of resources under the ground, but a dearth of buyers above it. The industry has proven it can live with lower prices, at least for a time. But expectations that developing countries, especially in Asia, would gobble up as much oil and natural gas as they could get their hands on aren’t panning out.

“Ultimately, in the long term, it’s about demand. You can produce as many barrels as you want, but if no one wants them, it doesn’t really matter,” Burkhard said.

Photo credit: JOE KLAMAR/AFP/Getty Images