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Tue 16 Dec 2014 03:53 PM

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Oil prices are now unsustainably low: Kemp

Reuters market analyst John Kemp says if prices remain at current depressed levels, almost all shale drilling activity will eventually cease

Oil prices are now unsustainably low: Kemp

Oil prices have now fallen to an unsustainable low level. Futures contracts for Brent and WTI have fallen below $60 and $55 per barrel respectively but many crude producers are receiving much lower prices.

Plains Marketing, for example, is now offering just $39.69 per barrel for Williston Basin Sweet crude and less than $50 for a wide range of other US crude oils, according to its latest pricing bulletin, published on December 15.

Billions of dollars of capital expenditure projects have been or will be postponed by the major international oil companies, independents and shale producers, which, if they all remained cancelled, would generate an enormous shortfall in oil supplies by the end of the decade.

At these prices, shale production on most leases across the United States cannot breakeven. Only a few of the most favourable areas with the best geology and low transport costs remain profitable. Even in these cases profit margins are razor thin.

If posted prices remain at current depressed levels, almost all shale drilling activity will eventually cease, and US oil production would start to fall rapidly towards the end of 2015 and into 2016 as output from existing wells starts to decline.

Just as prices were unsustainably high when Brent was trading above $100 throughout most of 2011-2014, encouraging too much drilling and conservation, oil prices have now plunged to an unsustainably low level.

The market has over-reacted to signs of an impending surplus in production in 2015 by cutting prices to a level that will cancel not just marginal projects but almost all new drilling given enough time.

It is a classic bubble - the mirror image of the frenzied rise in prices towards their peak at $147 per barrel in July 2008 ("Oil market is trapped in a negative bubble" Nov 14).

Like any bubble, it is impossible to predict how long it will continue to inflate or how far prices might eventually be distended before the bubble bursts.

In a bubble, prices tend to become far more distorted than rational observers thought possible before correcting, so there is no reason why oil prices cannot fall further in the short term.

But bubbles also tend to be fairly short-lived because their internal dynamics are so unstable and the divergence between market prices and underlying supply/demand fundamentals becomes too stretched to ignore ("Behavioural explanations make sense of oil's plunge" Dec 1).

In 2007/08, it took Brent prices nine months to double from around $75 in Oct 2007 to peak just below $150 in July 2008. In 2014, it has so far taken six months to halve from $115 to $59.

If it is impossible to predict how low prices might fall before correcting it is at least possible to surmise the turning point is not far off in terms of time.

The four previous plunges in oil prices over the last four decades (1985/86, 1997/98, 2000/01 and 2008/09 were all quickly followed by price rises after the market over-reacted on the downside.

The market appears to be headed for something similar in the current environment as prices fall to levels which are simply unsustainable for more than short period of time.

John Kemp is a Reuters market analyst

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