The oil price saga continues with the oil minister of the UAE firmly stating that it won’t cut back production, even if oil prices are at $60 or even $40 per barrel.
The oil markets are taking this threat seriously, and prices are continuing to plunge – reaching depths not seen since the Great Recession of 2008 and 2009. Oil-related shares are getting pummeled daily.
All the predictions of peril and doom are taking their toll on investors. More and more people are scared to touch anything remotely associated with oil or gas. Many are equating the situation to catching a falling knife.
But OPEC’s efforts to drive U.S. energy companies out of business may actually be a boon for the long-term survival of the industry.
The Cost of Doing Business
OPEC seems to be betting that the U.S. energy industry will come to a screeching halt and wells will shut down overnight.
It’s a shortsighted play, at best.
Yes, global energy players will cut back production and exploration. That’s a mathematical certainty, and it’s already happening.
You see, there are several costs involved with the production of energy, specifically fracking. These include land, labor, energy, chemicals, and water. Throw in the cost of leasing equipment and transportation, and you basically have the entire mix.
At $60 per barrel, most fracking companies are marginally profitable, depending on their location. For example, the fields in the Mid Bakken, Woodbine, and Mississippian Lime regions can make money below $60, while areas like the Delaware Permian are losing money at $60 per barrel.
However, as production and exploration begin to slow, each of the variable costs mentioned above becomes cheaper. Wages fall as demand for workers dries up and layoffs begin. Land costs tumble as marginal players begin to sell assets to raise capital, and the underlying value of the oil is reduced due to market prices. Transportation costs fall as energy costs and supplies shrink. Equipment and servicing costs decline. In fact, the entire cost structure drops as a result of a recession in the oil patch.
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Granted, dropping production costs alone won’t save the oil players. But the advent of new technology could…
Survival of the Fittest
You see, some companies will innovate in order to undercut OPEC’s strategy now and in the future.
As prices stay low, marginal players will begin to disappear, and the stronger players will take hold.
These resilient companies will invest in better fracking methods, reusing chemicals, and waterless fracking to reduce the cost of production.
The wells that are unprofitable will be shut down until prices recover. But I stand firm in my belief that oil prices are much closer to finding a bottom than most think.
The timing of the OPEC announcement couldn’t have been better in terms of its effect. Year-end selling of oil “names” is exacerbating the fall as many fund managers get rid of (or pare down) holdings before portfolios are published for customers at the end of the year.
No one wants to be seen with a big position in an industry that’s perceived to be collapsing.
Yet, energy company insiders continue to buy the shares of their own companies – knowing full well that the industry is both cyclical and prone to massive panic selling. It’s happened before, and it’s happening again.
The long-term outcome is clear. The world needs energy to function. More energy usage in the future is inevitable, and this correction – like all those in the past – will prove to be a massive opportunity to buy at bargain levels.
And “the chase” continues,