The Oil Glut Grows by Guest Blogger Buck Klemkosky

The International Energy Agency (IEA) has estimated that crude oil inventories have swollen to 3 billion barrels, the highest level on record, representing more than a one-month global supply. Many oil tankers, typically used to deliver oil, have been converted to floating storage with more than 100 million barrels of crude oil sitting in tankers offshore as the oil glut fills on-land storage to near capacity. The economics of storing oil for future delivery is no longer profitable as storage rates have increased dramatically, meaning some of the 3 billion barrels will be taken out of storage in 2016 and 2017. In addition, the U.S. strategic petroleum reserve is at its 720 million barrel capacity as well as China’s and other countries.

The oil glut has grown because supply exceeds demand by approximately 2 million barrels per day (b/d), 96.5 million b/d of supply versus 94.5 million b/d of demand. This is due more to supply increases than demand. Most major oil-producing countries have ramped up production including Russia, Saudi Arabia, Iraq, Iran and several others. Meanwhile, oil production in the U.S. has proven more resilient than expected although its 9.2 million b/d production is expected to decrease in 2016 but not significantly enough to offset increased supply from other countries, especially Iran as economic sanctions have recently been lifted. The growth of oil demand has increased by 1% annually over the last decade and growth is not expected to increase going forward. Much of the increased demand has come from China and other developing countries but their economic growth has slowed dramatically. Peak demand is now of more concern than peak supply.

The fall of oil prices (West Texas Intermediate) to less than $40 in 2015 will have repercussions for the U.S., some positive and some negative. The energy industry was the big driver of employment growth and corporate investment since the Great Recession of 2007-2009. Already $200b of global projects have been cancelled or delayed and more than 250,000 workers have been laid off. Two-thirds of the oil rigs in the U.S. have been taken out of service. The Keystone XL pipeline has been vetoed but that will not have much impact as the U.S. already imports 3.4 million b/d of oil from Canada out of 9.5 million b/d total. Overall lower oil prices will be a plus for importing countries such as the U.S. as lower gasoline and fuel prices put more money in consumer pockets. The real hurt will be felt by the major oil-producing countries and companies as all of the OPEC countries, including Saudi Arabia, are facing huge fiscal deficits. Forty North American exploration and production companies have already declared bankruptcy with more to come.

It is difficult to predict oil prices but the IEA estimates that the best-case scenario for oil prices is $80 per barrel by 2020 and the worst case is $50 per barrel. Geopolitical instability in the Middle East is always a possibility and Saudi Arabia has recently stated it would like to see oil stabilized at a higher price. But Saudi Arabia has not committed to cutting production to balance supply and demand which has been its role for several decades. If low oil prices are the new normal, the U.S. will be a net positive beneficiary as consumers will enjoy lower energy prices for several more years.

Low Oil Prices? I don't think so.

Oil prices are low. Groovy! Hold on they tell me. Low oil prices are bad. What? Tell my new gas guzzling Santa Fe that lower gas prices are bad. Tell my wallet. What is going on here? We cried and moaned every time we went to the gas station for years and now that gas prices have dropped a few cents, we are supposed to see a crisis in the making? This is economics gone wild

Where to start? Basic economics. Suppose people want fewer Thingies. This leads to a lower price for Thingies. Firms supply fewer Thingies to the market. That sounds pretty intuitive. People want less so firms supply less. It happens all the time. So when global demand for oil started to fall and this caused the price of oil to decrease, it makes sense that oil firms produce less. What is the problem? The problem is that some folks are worried that the price will fall so far and get so low that most firms would lose money selling oil and the supply would dry up.

Now you see the rub. But come on guys – what are we assuming here about oil firms? Basically the worry warts are saying that firms are passive entities who bark at the ring of a bell.

First, is it not possible that oil firms could work harder at cutting costs to remain competitive at lower prices?

Second, is it not possible that firms could innovate or find better ways to make money with oil? Notice that when prices are high and rising there is very little incentive for oil firms to cut costs and innovate. But when they are falling, the stakes are much higher and there is plenty of incentive for protecting profits.

Third, is it not possible that firms who got rich when oil prices were super high might have invested or saved some of that money for a rainy day?

Finally, is it possible that oil prices are not yet really so low that we have to worry?

It is this last question that I want to address here. Are oil prices really so low? So I found some data on crude oil prices. You can get data back through 1776. Ha ha. No you can’t. But you can get them back to before I was born! I found monthly data on crude prices and I mostly wanted to focus on when they got interesting – after the early 1970s.

Before 1973 crude went for about $3 a barrel.

After two oil crises we found oil near $40 by 1980. You have to admit that is quite an increase. My allowance didn’t go up nearly that much.

At that time a strange bunch of fellows who were part of a group called the Club of Rome predicted that oil prices would soon reach $100 per barrel. Unfortunately their timing was quite wrong as oil prices fell below $40 very soon and basically fluctuated for the next 24 years! Yes, it took until 2004 before oil prices reached the magic $40. $100 per barrel sounded pretty stupid.

One reason for telling the above story is that we have mental giants who like to extrapolate the latest changes into the forever future. What goes up must go up! That same logic prevails with some people today. Oil prices went down so they must keep going down. Maybe they would go to -$100 if only prices could be negative.

The Club of Rome must have started singing JD drinking songs because they finally got their wish in 2008 when oil prices climbed to about $133 per barrel. I wish all of my forecasts would turn out correctly 38 years later!

Okay, Larry get to the point. As I am typing a barrel of crude oil costs about $66. Is that a low price we should worry about? Well, it is low compared to the $133 of 2008. But then it is quite high compared to the $39 per barrel of February of 2009. Are you getting seasick yet? Yes, oil prices oscillate like crazy. But even more telling is the fact that $66 per barrel is HIGHER than virtually every month since 1946 except for a little burst in 2006 and another one from about 2010 to sometime in 2014. 

If oil companies could make money on oil during all those months when it was priced at $66 or less, then I am guessing they will be okay now and they will continue producing oil. While $40 dollars a barrel might be a little tougher on them, I am guessing they could survive prices less than $66.

Some of you sharp cookies might worry that I haven’t accounted for the general level of prices. After all, $66 dollars today buys a lot less than it would have bought some years ago. So I deflated the CPI energy Index with the CPI. Guess what? Even if you account for general inflation, energy prices today are higher – not lower – higher than in most months since the 1970s. That is, a dollar earned from energy buys more than it did in the past. For example, in 2002 a dollar of energy could buy only about 60 cents of consumer goods and services. In September of 2014 a dollar of energy could buy a whole dollars-worth of consumer goods and services.

So whether you deflate or not, oil prices are not low at $66 per barrel. If anything they are high. I am not about to begin weeping JD tears for these energy companies. Most of them will do fine, especially the ones that aggressively invest, manage costs, and innovate.   While supply of oil might decline because of good economic reasons, it is hard to imagine a future energy crunch like we had in the 1970s. In the meantime, enjoy pulling up to the pump and paying  $2.something for a gallon of gas.