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The Four Real Reasons Oil Prices Are Slipping

This is a syndicated repost published with the permission of Money Morning. To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.

Years ago, a legendary wildcatter told me you have to smell the crude and get it under your fingernails before anybody should call you a genuine oilman.

Well, yesterday I was addressing a convention hall full of them.

I’ve been at the annual meeting of the Kansas Independent Oil and Gas Association (KIOGA). More than 800 industry insiders were in attendance for my keynote address in downtown Wichita.

OilI always look forward to spending time with the “little guys” in oil exploration and production (E&P). These are the fellows who have comprised the bedrock of American domestic production for over a hundred years – the very small, very local companies. Many are running some of the smallest operations around. The average KIOGA member company has just more than three employees!

And in my address, I shared with them the four real reasons oil prices are declining.

Here’s what I discussed in my briefing…

Why Small Oil Operators Are Hurting

Throughout the decades, small E&P outfits have endured market downswings, vicious weather, profit constrictions (or outright profit disappearances), and virtually every conceivable problem with oil field service, equipment/supply prices, and the cost of running debt.

This year, all of these crises – and more – have hit at once.

There were those in the audience who knew they would not make it to January. But this is also a resilient bunch. The collective history sitting in front of me was flat-out extraordinary.

However, they face difficult times.

As crude settles in below $50 a barrel for WTI (West Texas Intermediate, the benchmark used in New York for futures contracts), operators at the wellhead are making about 15% below that figure. To survive, they need to be lean and selective in drilling.

The plunge has hit hardest those companies developing deep drilling operations in shale and tight formations, those requiring horizontal drilling and fracking. Without a price for oil of around $65 a barrel, there is no likelihood that forward investment commitments can be sustained. Here is where the main cuts in new projects have been taking place.

The Best Strategy for Survival

It just so happens that the best strategy to use in such times is an approach the folks in Kansas know well. It has allowed them to weather storms before, and it will do so again.

Yes, as I have often said, a rising tide does not lift all boats. Yet it is also true that a declining water line does not scuttle all boats, either. In a low price environment that nonetheless has strong demand, a specific positioning in known and prolific, completed infrastructure, along with attention to managing forward capital expense, is essential.

Most of the folks in the audience already knew that, but not all of them are able to move on it. Vulnerability is intensifying.

Deliverance from the current malaise is not going to be across the board. In fact, that was part of one of the four primary points I wanted to make in my address.

The Four Reasons Behind the Decline in Oil Prices

I began by laying out the current dynamics attending the price decline: supply gluts, the value of the dollar, excessive short positions on crude, OPEC-related sovereign wealth funds undercutting the price of their own production, and the widening spread between “paper” barrels (futures contracts) and “wet” barrels (the actual consignments of oil in trade).

The current price of crude oil in New York (WTI) is some $11 below where it should be based on straight market factors. Meanwhile, Dated Brent (the benchmark set daily in London) is closer to $15 below “fair market value.” The differential is the result of elements having very little to do with either supply or demand dictating price.

The next two factors I have also considered at length: the changing nature of the oil balance and the acute crisis in energy debt.

The balance considers sources of supply and expanding end use markets. Supply is now coming from places quite different than only a few years ago, as the “call on shale” has begun to replace the more traditional “call on OPEC.”

Meanwhile, the debt issue involves the increasingly too expensive interest that must be paid when high yield (i.e., “junk”) bonds are issued. The ability to roll over debt, a staple of cash poor operators in the United States, is vanishing, as is any genuine option of hedging current prices against future prospects.

The Coming Wave of Consolidation

This sets the stage for my fourth and final main point in Wichita. We are moving again into a major period for mergers and acquisitions (M&A). Some companies will simply go belly up. On the other hand, others having choice leases and well operations (but becoming exceptionally weak in capital) will become primary targets for takeovers.

However, there is an additional wrinkle emerging. A widening number of companies are prepared to sell select wells and leases for the immediate funds needed to stay afloat until the broader market stabilizes.

In these situations, whole companies are neither going under nor being acquired. The focus here is on selective assets.

Remember this. Because it is the key to a major initiative we are about to open up. And I’ll be there, monitoring the situation, every step of the way.

One Word, Two Syllables: Iran, for the first time in a decade, has a genuine opportunity to increase oil and gas production, investment, and exports. All of which would inject very badly needed revenue into a domestic economy that collapsed some time ago. But right now Iran is playing charades with domestic consumption…

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The post The Four Real Reasons Oil Prices Are Slipping appeared first on Money Morning. Reposted with permission.

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