Report

Oil Prices Have Hit a 10-Year Low. They’re Not Going to Stay There.

Oil Prices Have Hit a 10-Year Low. They’re Not Going to Stay There.

Never mind roiling tensions between Saudi Arabia and Iran, the Islamic State’s continued assault on Libyan oil infrastructure, or North Korea’s purported detonation of a hydrogen bomb. Crude prices hit their lowest levels in more than a decade on Wednesday, plunging through a rotted floor and falling more than 5 percent in trading in New York and London to about $34 a barrel — culminating a dizzying crash from heights of more than $100 a barrel in the summer of 2014.

Which makes for an odd time to start worrying about all the things that threaten to drive oil prices sharply higher. Yet that’s exactly what many in the industry are starting to do.

The current oversupply of oil, which is keeping prices low, is also setting the stage for oil’s own rebound. The U.S. shale boom, which has gushed more than 4 million barrels of oil a day onto global markets, is fizzling, with U.S. production this year set to shrink for the first time since the bonanza began. Investment across the global oil industry is in free-fall like it hasn’t been for 30 years, which makes it harder to keep today’s wells pumping and puts tomorrow’s projects on ice. Global demand for oil, meanwhile, is still growing, if not quite as fast as last year’s heated pace.

In other words, an oil market that currently looks ridiculously glutted is poised to tighten up dramatically later this year and could send oil prices back to the triple digits with all sorts of nasty consequences for a still-wheezing global economy.

“Nobody is more bearish than we are in the short term, and nobody is more bullish than we are for 2018, 2019, and beyond,” said Robert McNally, president of the Rapidan Group, an energy consultancy. The cocktail of shrinking supply and rising demand, coupled with the kinds of geopolitical shocks that these days pass unnoticed for oil traders, means today’s cheap oil might soon become just a fond memory.

“Oil will be back in the $100s by the end of the decade,” McNally said.

In the meantime, all signs point to even lower prices for crude. Asian economies, the motor of global growth, and demand for crude are both stumbling. Prolonged malaise in countries like China could further dampen already tepid expectations for oil-demand growth this year, which would push prices even lower.

Meanwhile, oil storage tanks around the world are brimming already and getting fuller because the world still pumps more oil every day than it burns. The U.S. oil storage facility in Cushing, Oklahoma, holds more crude now than ever before. At the same time, Iran, sidelined from oil markets since 2012, is gearing up for a return as Western sanctions are lifted as part of last year’s nuclear deal. If Iran is able to increase oil output and exports more quickly than experts expect, that could further flood a glutted market.

And through it all, major oil producers — both those inside OPEC, led by Saudi Arabia, and those outside, like Russia — continue to pump with abandon.

But low prices, which did nothing to discourage oil producers last year, are finally starting to take a toll. Thanks to heroic efficiency gains, U.S. shale oil production miraculously continued to climb last year despite plunging prices. But there aren’t any more rabbits in that hat: The U.S. Energy Information Administration expects U.S. shale production to drop this year by about 1 million barrels a day from last April’s peak. Oil rigs in North Dakota’s shale patch, for example, have fallen to their lowest level since 2009 because producers that struggled to break even with $50 oil cannot make ends meet when crude fetches $30-something a barrel.

Overall, after record-setting growth last year, non-OPEC oil production is expected to shrink this year by about 600,000 barrels a day, the first contraction since 2008.

That alone would make for a much tighter oil market. Experts figure the world pumps about 1.5 million barrels a day more than it consumes. But demand is expected to grow this year by at least 1.2 million barrels a day, nearly absorbing the whole surplus. Remove another 600,000 barrels a day of supply, and there’s no surplus at all. Wood MacKenzie, the oil and natural gas consultants, expect oil inventories to start shrinking increasingly rapidly in the second half of 2016.

The price plunge has set the stage for other, longer-term impacts by discouraging capital investment across the industry. Oil companies need to invest in existing projects to counteract the natural decline of older oil fields by, for example, injecting tired wells with fluids to maintain pressure and keep output steady. Massive investment is also needed to fill future pipelines with big, ambitious projects like deepwater rigs or oil fields in the Arctic, which will be needed to meet global demand in the next decade.

That investment is drying up. Big-ticket projects, like Shell’s gamble in the Alaskan Arctic, have been iced. Countries like Iraq are scrambling to find the cash to pay for much-needed oil-infrastructure improvements. Brazil’s Petrobras, whose deepwater fields represented the industry’s most ambitious investment plan, is battening the hatches and slashing future production estimates. Canada’s oil sands have gone from boom to bust in the space of a year.

Overall, capital expenditure in the oil and gas industry shrank dramatically last year and is set for another 25 percent contraction this year, figures Moody’s, the ratings agency. Years of back-to-back belt-tightening are almost unheard of in the industry; the last time it happened was during the oil-price collapse of the mid-1980s.

“It may take several years, but all those capex reductions will really start to bite,” said Jason Bordoff, a former energy advisor to President Barack Obama’s administration and now director of Columbia University’s Center on Global Energy Policy.

A tighter market would mean gradually higher prices down the road at any rate. But it could also set the stage for dramatic price spikes when something went awry, like the recent heated confrontation between Iran and Saudi Arabia or the Islamic State’s relentless assault on Libya’s teetering oil industry. That’s because the oil industry’s natural shock absorber — spare production capacity that can quickly be called on to fill any unexpected shortfalls — isn’t really there anymore.

OPEC’s spare capacity is at historically low levels because everybody is pumping flat out to make what money they can with low prices. Estimates vary, but the amount of extra oil that OPEC, essentially Saudi Arabia, could quickly get to the market is estimated at between 1.25 million barrels a day and 2.3 million barrels a day, a hairbreadth margin in a global oil market that pumps almost 100 million barrels a day.

With little buffer set aside for a stormy day, a taut market could be especially vulnerable to just the kinds of geopolitical shocks that have been proliferating in recent months, from the Persian Gulf to Syria to Russia to the South China Sea.

“The oil glut has dwarfed any focus on spare capacity,” said Richard Mallinson, an analyst with Energy Aspects, a consultancy in London.

“But with such a narrow buffer, you wouldn’t even need a big disruption to see a spike. A few little things could really wreak havoc.”

Photo credit: MAERSK DRILLING/Flickr