Sector News

Why oil will crash again in 2016

November 17, 2015

In 1950 the American mathematician and economist John Forbes Nash, Jr. earned his PhD with a dissertation that explained why markets can gravitate towards a sub-optimal equilibrium.

What is now known as a Nash Equilibrium results when all economic actors know that a different strategy would be better for them, but they also know that this different strategy will only be better for them if all other economic actors also change their strategy, as a consequence of which no-one will do anything.

This situation is effectively what caused the oil price crash of 2014. As I documented in ‘The trends that will keep the oil price below $60/B’, the historically high oil price of the period 2000 – 2013 caused a massive influx of money into the oil & gas industry. This money was used by the oil & gas industry to increase production capacity, under the assumption that economic growth would increase global crude oil demand to such an extent that the market would be able to absorb the additional barrels. Since 2008, however, economic growth has largely disappointed. (Pretty much every quarter since the IMF has had to revise its global growth forecast downward.) Consequently, a crude oil supply glut built up. To maintain the (then still) comfortable price level the oil & gas industry should have gradually lowered production, but it didn’t. The producers were enjoying the high price too much and everyone knew that a reduction in his or her production would only support the price if everyone else did the same. So no-one did anything, hoping someone else would. This Nash Equilibrium lead to a steady increase in the imbalance between supply and demand, until it reached close to 2 million barrels per day in the 4th quarter of 2014, causing the price to collapse.

Unfortunately, this crash has not broken the market free from the Nash Equilibrium. Rather, it has locked it into another one.

It is well known that despite impressive improvements in efficiency over the last year, a substantial part of the current tarsand and shale operations in North-America is unprofitable in the current price environment of $40 to $50 per barrel. Producers in these (and other) high-cost areas would actually make more money if they shut in production, but only very few actually have. In fact, global liquids productions has increased, from 92.5 million barrels per day during the 2nd quarter of 2014 to 96.3 million barrels per day in the 3rd quarter of 2015.

The reason for this surprising fact is that the oil & gas producers know that the first one to take the rational step of reducing production will lose if all others don’t follow suit. Hence OPEC’s decision not to reduce its production – why would it reduce in the knowledge that those who do not reduce would then reap the benefit of a higher prices?

The consequence of this new Nash Equilibrium in the global crude oil market is a massive increase in inventories. According to the International Energy Agency the global stockpile of crude oil now stands at almost 3 billion barrels. Around the world, land storage sites are essentially full and producers and traders have turned to storing excess crude in tankers, driving up the day rate of supertankers to around $100,000 per day, its highest level since 2008.

This new Nash Equilibrium can end in only one way: another crude oil price crash.

So far, the high-cost producers in North-America have been enabled to continue uneconomical production by banks providing credit on terms equal to, or even better than those during the boom years. (Clearly, the banks are part of the current Nash Equilibrium. Every one of the original lenders to the shale industry knows that it would only be sensible to cut back lending, but he or she also know that whoever cuts back credit first will lose because his borrowers will go bankrupt, unless all other banks do the same at the same time.) In addition, private equity investors have stepped in, hoping to snap up crude oil assets on the cheap and willing to finance unprofitable operations until the oil price recovers.

Therefore, unless the price goes down further, shale production will not collapse any time soon and the supply glut will remain. This effectively means that in the absence of a sudden uptick in crude oil demand (which is highly unlikely, as the Chinese economy is slowing and the country can not continue to build up strategic petroleum reserves), the price will go down.

With land storage already full and floating storage increasingly uneconomical due to the high day rates for supertankers, it is just a matter of time before the market realizes it doesn’t have to buy crude at oil $40 per barrel. Because producers are getting ever closer to the situation where they simply have to sell their production, at any price, due to a lack of other options. This will change market sentiment and drive the crude oil price further down, even making $20 per barrel a distinct option.

In other words, the current Nash Equilibrium will be broken up by another price crash, one that will really reset the industry back to normal and rebalance crude oil supply and demand. Only from that point onward will the rule that the crude oil price is determined by the cost of the marginal barrel apply again, which, as I explained in ‘The trends that will keep the oil price below $60/B’, I foresee to be around $60 per barrel.

But we’ll need to go down first, before we can start going up again.

By Andreas de Vries

Source: Oil Voice

comments closed

Related News

August 23, 2019

The higher purpose of being a CEO

Borderless Leadership

LinkedIn Twitter Xing EmailWhen I left my second large company experience to become President of a small manufacturing company I did so driven by ego; I fancied the title. Soon […]

August 23, 2019

As Brexit nears, Britain’s drugs, devices and pricing regulators seek the exit

Life sciences

LinkedIn Twitter Xing EmailFirm details on exactly how the U.K. will regulate new medicines is still to be decided after it leaves the EU later this year (caveats on timing […]

August 23, 2019

The Simply Good Foods Company acquires Quest Nutrition for $1bn

Food & Drink

LinkedIn Twitter Xing EmailThe Simply Good Foods Company, the owner of Atkins-branded food products, has secured a deal to acquire protein snack maker Quest Nutrition for $1 billion. Quest, which […]

How can we help you?

We're easy to reach