Why Oil Is Cheap in October 2015 (Part 1 of 2)

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October 27, 2015

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by Robert E. Kozak* (Advanced Biofuels USA) Conventional wisdom about declining oil prices, mostly originating from US Department of Energy/Energy Information Administration (DOE/EIA), says the fall of oil prices over the past fifteen months is simply a result of an increase in oil supply, mostly from Saudi Arabia. As is the case with most conventional wisdom, it is wrong.

The reason oil prices fell is not simply because of increased supply but instead --

Because significant supplies of oil were available at below market prices beginning in the summer of 2014.

That’s right, not an increase in supply, but an increase in supply at below the market price.

Let’s look at the data, not at EIA reports or financial blogs.

In the summer of 2014, ISIL (Islamic State of Iraq and the Levant) launched a daring offensive that captured a great deal of western Iraq. Among their trophies were oil fields. Immediately, ISIL began selling the oil at prices around $10/barrel. US sources reported at the time http://www.euronews.com/2014/10/23/washington-isil-makes-dollar-1-million-a-day-by-selling-oil-including-to-its-/ that their income was $1 million/day. At $10/barrel that would be about 100,000 barrels/day.

On the surface this might not appear to be much given that the US imports over 8 million barrels/ day. However, with its history of price volatility as a guide, the world oil market is very nervous. One small pebble in the pond, 100,000 barrels at $10 when the composite world price (average of Brent and West Texas) was about $107/barrel, can set off a tidal wave. Saudi Arabia saw the effects first and up close - along its northern border where tankers with cheap ISIL oil were rushing to delivery points.

Saudi oil people most likely drew two conclusions from these events.

As small as it was, ISIL oil was providing downward pressure on oil prices just as Chinese demand was softening.

The coming fighting between ISIL and Kurdish forces would put other low-cost producing fields into play and further increase downward price pressure. Either ISIL would capture them or the Kurds would market them independently of their arrangement with Iraq to increase their income to pay for the war.

By late summer of 2014 Saudi Arabia, as the world’s largest producer of low-cost oil (about $5/barrel to produce as compared to US shale oil of about $55/barrel), had to respond in some manner before the market got out of their control. They could either try to maintain oil prices by cutting production or they could ride the ISIL downward signal by increasing production. As we know, Saudi Arabia chose the latter course of action.

Also, as we found out, they tied this increase in production to a geo-economic goal of knocking the US and Canada (the two highest cost producers) out of the oil producing business. What will be interesting to find out in the future is whether this was a long term objective of Saudi Arabia and they were just waiting for the right trigger to enact it.

By January 2015 the world composite oil price had fallen to about $64/barrel. This was still slightly above US shale oil production costs, so the fall-off in US drilling rigs was only 7.9% from the October 2014 peak of 1609 rigs. US conventional wisdom maintained that all was well. Supply was increasing in an acceptable manner, prices would stabilize and the world economy would grow with stable oil prices of about $60/barrel.

While the first six months weren’t good, US drilling rigs fell to 631 (39.2%) by June, things did appear to be looking up in July. For the first time since US drilling rig numbers began to fall, US DOE/EIA reported that US oil production had fallen at least 600,000 barrels/day since the EIA reported peak in April 2015. They also projected additional decreases until oil prices rose. This led to a momentary stabilization in oil prices and a small increase in US drilling. On August 28^th 675 rigs were reported to be in action. However, remember the concern about Kurdish oil fields?

As reported by Bloomberg http://www.bloomberg.com/news/articles/2015-07-14/iraq-s-kurdish-region-exporting-550-600k-b-d-oil-of-own-output and others, in June 2015 Kurdistan stopped the approximately 600,000 barrels of oil produced daily in their autonomous region from being exported by the Bagdad oil ministry which was returning a very small margin above the production price to the Kurds. Instead, in order to pay for the war with ISIL, the Kurdistan Regional Government (KRG) began selling the oil directly at below the world market price. Some reports placed the prices at about $25/barrel.

What was the result of these two oil supply actions? If the total oil production hypothesis was correct, the reduction in US production would have a slight positive effect on oil prices since the oil supplied by Kurdistan remained constant. However, if the two-price oil market hypothesis is correct, the international oil price would fall somewhat since the Kurdish decision resulted in an additional 600,000 barrels/day at well below the market price which, despite its nervousness did have enough supply slackness (probably due to DOE/EIA overestimates of supply) to compensate for the loss of the 600,000 or so barrels at market price.

Oil prices fell in the 3^rd quarter of 2015 and continue into the 4^th. As of October 27^th West Texas is $42.88 and Brent $46.63.

Recent US reductions in production and these continued price decreases probably cause continued head scratching among the total oil supply hypothesis people. As reported in the October 26^th Wall Street Journal http://www.wsj.com/articles/after-years-of-decline-u-s-oil-imports-rise-1445851800, US oil imports are increasing because of new decreases in US shale oil production. Eastern oil refineries increased imports from about 290,000barrels/day for the week ending October 9^th to 883,000 during the week ending October 16^th (the newest data available) while Gulf Coast refineries increased their imports by 600,000 barrels/day over their 2014 totals in the same period.

Substituting international market priced oil for about 1.2 million barrels/day of US produced international market priced oil being taken off market would seem to argue for stable or slight price increases. This especially seems to be the case since at this point most producers would like to see the international composite price rise because low oil revenues are causing them to use their saved sovereign oil funds (aka “retirement funds”) for immediate operational costs and citizen health care expenses. Denmark is one such oil producer.

Instead, prices fell on the October report. Could this be because additional below international market price oil is becoming available?

Many, if not most media reports about oil prices contain some mention of rumors that because of the recent US-Iran nuclear agreement Iran would be offering oil at or below the world market price to build market share. The October 2015 decrease in oil price despite a measurable decrease in 4^th quarter US oil production (somewhere between 13% and 19%) shows that oil buyers and sellers seem to think this is happening.

While nearly everyone agrees that this rapid pumping of low-cost-to-produce oil only reduces how long it will be available and $100+ barrel prices will return, it also seems clear that there is sufficient below market priced oil available that everyone will have to deal with low priced oil for the short term, i.e. 12 to 24 months. Saudi Arabia is even included. They are in a situation where the reduction in their oil production needed to raise prices to $80/barrel cannot be done without losing face both in the Middle East and internationally.

The question therefore becomes, what combination of the following three situations will reverse oil prices?

What reduction in US shale and Canadian sand oil production will overwhelm the effect of below-market prices oil?

How long can Iran sell oil at prices below what is needed to run their economy?

When will ISIL and/or Kurdistan have to raise prices to pay for oil system maintenance/production and replacement of war fighting equipment?

Decrease in US Oil Production: Of these three, future US oil production is probably the easiest to predict. The low point in production is when the oil from the 1,000 fracked wells, the difference between the high point of 1600 wells in October 2014 and the current number of about 600, can no longer be pumped. That very significant date will probably be reached sometime in 2016 since published reports estimate the average life of fracked wells as about 18 months.

Iranian Oil Prices: Various parts of the Iranian government have signaled that economic growth is one of the primary goals of the recent nuclear accord. Banks are going to want secured payments for the loans needed to rebuild Iran. These financial agreements will be the primary driving force on Iranian oil prices. Look for a multi-year stepwise approach that will not upset demand until revenues are balanced at higher prices/lower export production.

Kurdistan and ISIL War: Unless the US and/or Russia destroys all their oil production systems, this could go on until they pump out the last drop. Remember, in time of war oil prices are not market driven. Ask the UK, France, Russia, or China how much the US charged them for oil in WWII.

My prediction? With the US Presidential election in November 2016 political games will be played by the Obama Administration to delay an oil price rise until after it’s over. So, unless US oil production craters in the summer of 2016, Iran and Saudi Arabia jump on the opportunity, or a Gulf hurricane hits, don’t expect $100/barrel until the US has a new President.

This is Part 1 of a series by Bob Kozak exploring the relationship of oil prices and the future of renewable liquid transportation fuels.

*Robert E. (Bob) Kozak is the founder of Atlantic Biomass, LLC, and a co-founder of Advanced Biofuels USA. Having worked for about 40 years in the transportation, energy, environmental, and government relations industries and in enzyme development, he serves as a fuels/engines and policy expert for Advanced Biofuels USA. He can be reached at atlanticbiomass @ aol.com

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