Stop the Madness

Jim Brown
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Crude prices continued to decline on Sunday evening to trade at $89.50. Multiple factors are weighing on prices and it is madness to think that it will continue.

Over the long term everyone knows crude prices will rise. It is a fact of life that oil prices will rise because we continue to consume more every day and the cost of finding and producing it will also continue to rise. Salaries for workers, rig costs, transportation costs and of course well costs will rise.

Continental Resources said they were going to spend an extra $2 million per well on additional length to the laterals, extra stages and 2-3 times as much proppant. Everyone else will eventually follow suit. This is in an effort to squeeze every drop they can out of the wells.

Unfortunately this constantly rising cost of exploration and production will raise the cost of every barrel produced. With WTI at $89.50 today the selling price for Bakken is in the mid to high $70 range. The steep discount is because of the transportation cost by truck and rail since there is not enough pipeline capacity to move the oil to market.

I am sure you have heard recently that the marginal cost of oil production from many shale wells is in the $80 to $85 range. With wells costing $8-$12 million each if you don't hit a gusher the cost per barrel is very high. The average Bakken well is in the 900-1200 bpd range to start and they deplete about 65% in the first year.

If oil prices continue lower to the $85 range as some expect then prices at the pump in the Bakken could fall to $70 as producers try to underbid everyone else to make sure their oil is purchased.

If your marginal cost is $80 and the oil is selling for $70 then you have two options. You either halt production until the prices rise again or you take a $10 loss on every barrel you produce. Some producers will take the loss because they need the cash flow to fund ongoing operations. Some producers don't have aggressive drilling programs to support so they will likely curtail production until prices rise again.

Normally when Brent prices decline below a "fair" price as defined by Saudi Arabia we see OPEC reluctantly lower production quotas to push the price back up. That does not appear to be the case today.

Last week Saudi Arabia signaled it was ready for a price war with the other OPEC nations and global exporters. Instead of cutting production Saudi cut the prices per barrel by $1 for exports to Asia. That put prices at the lowest level since 2008.

The price cut appeared to signal that Saudi was not going to cut production and instead was going to try and undercut everyone else to make sure there was a home for their oil.

There could be multiple reasons for this tactic. Saudi Arabia is not happy with the way the negotiations are going with Iran and the 6 western nations over the nuclear issue. Iran is dominated by Shia Muslims and they are constantly trying to create unrest in Sunni dominated Saudi Arabia. Selling oil cheaper penalizes Iran and restricts their cash flow.

Also, Saudi is not happy with the developments in Iraq. They view the takeover by ISIS and the complete breakdown of the Iraqi military as a disaster.

Saudi Arabia is ruled by the Sunni majority, which accounts for about 85% of the population. The other 15% are Shia Muslims and they are under constant pressure from the government. According to a 2009 Human Rights Watch report, Shia citizens in Saudi Arabia "face systematic discrimination in religion, education, justice, and employment." When the Iraq military failed to control the Sunni ISIS invasion it put Saudi Arabia in the position of having to join the U.S coalition to attack ISIS even though the Saudi royal family is Sunni. The royal family had to oppose the ISIS caliphate at least on the public stage. It is widely thought that the royal family was supporting ISIS behind the scenes.

When the Iraqi military failed to stand and fight it angered Saudi Arabia and by starting a price war over oil they can punish Iraq for their military failure.

Also, Saudi Arabia is spending $130 billion to provide housing and jobs to keep the population in line and depress the Arab Spring. If Saudi cuts back on oil production they cut back on their income. Since Saudi has about 2.5 mbpd of excess capacity they can actually lower their prices and increase their production to still bring in the same amount of money. They can punish the other Middle East nations for not keeping their citizens in line and remind everyone that they are still the big dog in terms of production.

Lastly, Saudi Arabia feels threatened by the shale oil boom in the U.S. and around the world. Other nations are starting to get into the act but to a much smaller extent than the USA. Saudi knows the cost of production is high and by pushing down prices they can discourage new investment in shale exploration and slow future production growth, which would support prices in the long run.

In the short term Saudi appears to be saying we are going to continue producing oil at the current or even higher. Other countries also desperate to keep the cash flowing will have to produce more to make up for the drop in price. This price war could have dramatic consequences for the U.S. if it continues for very long. U.S. drivers will benefit from the drop in Brent crude, currently at $92 and the lowest level since June 2012. Gasoline prices should decline to $3 and well under that level in some regions.

Oil Inventories

U.S. crude inventories declined another -1.4 million barrels to a new three month low. Crude imports rebounded +414,000 bpd from the abnormally low level of 6.87 mbpd last week. I theorized last week that going from a three-month high in imports to a three-month low over the space of two weeks was an accounting problem rather than reality. Imports returned to normal this week at 7.28 mbpd.

However, refinery demand for crude fell sharply by -525,000 bpd as a result of refinery utilization declining from the high for the year at 93.4% to 89.8% as maintenance downtime finally began.

U.S. production declined slightly from 8.87 mbpd to 8.84 mbpd. Cushing's inventory rose slightly from 20.2 to 20.5 million barrels.

Gasoline inventory declined by -1.8 million barrels to a new three month low. Production declined -90,000 bpd and imports were almost unchanged. Demand declined -121,000 bpd. We are definitely in the slow demand season for gasoline but that will begin to increase after Halloween.

Distillate inventories declined -2.9 million barrels to 125.7 million but that is still near the recent highs. Distillate demand rose +367,000 bpd and imports declined -162,000 bpd. Inventories are still nearly -3% below year ago levels. Next week we should see the decline in demand from the Chicago FAA sabotage where more than 2,000 flights were cancelled. All these numbers run about a week behind.

The slowing economy in Europe is probably softening the export market for gasoline and diesel. This should help push prices for refined fuels lower in the U.S. along with the decline in Brent prices.

In the graphic below green represents a recent high and yellow a recent low.

Propane inventories rose .44 million barrels to 79.56 million. Inventories are at the highest level since October 1998. Demand rose to a three week high from 1,080,000 bpd to 1,160,000 bpd. Propane supplies are not likely to run short this winter. Next week is typically the peak inventory level for the season.

Natural gas inventories rose +112 Bcf to 3,100bcf. Inventories are still -11.4% below the five year average at 3,499 Bcf. There are only 4 weeks left in the injection season and at the current rate we may only reach 3,500 Bcf. That is still about 400 Bcf below where we need to be going into the heating season.

The blue line in the chart below shows the current inventory relative to the five year average.

There are no storms or potential Atlantic storms in the long term forecast.


The S&P futures are up +5.50 on Sunday night and WTI futures are down slightly at $89.50. It looks like the markets may try to extend their Friday short squeeze on Monday and I sure hope it sticks. The major indexes rose only to resistance on Friday and an gains on Monday should produce further short covering.

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Jim Brown

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