When Will Oil Bottom?

Not until the discount of WTI to Brent disappears.

If one of Saudi Arabia’s objectives is to curtail American shale oil production, then it bears to reason that this objective will not be attained until Brent and WTI trade at parity once again. In recent years, the surplus production of American oil coupled with the legal ban on US oil exports has resulted in a discount of WTI vs. Brent. Going forward, there will be no incentive for a domestic oil buyer to replace US oil (WTI) with foreign oil (Brent) as long as the first is at a discount to the second.

Regardless of the prevailing price, US shale oil production will continue to grow through this year; many wells have already incurred their upfront costs and need the cash flow from production to recoup those costs. When oil was flying high near $100, these operating cash flows were expected to widely offset the upfront costs and to generate an attractive total return for the venture. Now with oil near $50, many will not generate a positive return but they still need the cash flows to get as close as possible. Despite a declining price, there is therefore an incentive to keep pumping for as long as possible.

In theory, at current prices, shale production growth will taper off and could even reverse after a few years. This at least is OPEC’s calculation. Markets discount the future and OPEC’s current price war cannot be judged a success until the WTI discount to Brent has disappeared.

It appears on its way to doing so, having fallen from a high of $9 and a 2014 average of about $6 to little over $2 today (see chart).

WRIBrent20150108

It is a fair assumption that the discount will continue to shrink if the price of oil continues to fall. At $40 or $30, it may disappear completely, But at those levels, there will be other unforeseen consequences. For example, if the US economy weakens due to job losses in Texas and North Dakota or due to more weakness overseas, there would be less demand for oil, resulting in another domestic oil glut and another widening of the discount. Stay tuned.

Oil20150108

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