Is an oil black swan looming?

January 14, 2015 06:55 PM

The recent dramatic drop in crude oil prices has been blamed on Saudi Arabia and OPEC trying to take a shot at U.S. shale oil producers. With its recent decision not to cut output and Iraqi crude shipments expected to increase to a record level the real question is: Can the members of OPEC even afford to cut output because of this drop?

Traders and portfolio managers taking a common sense approach might be asking, “Are they messing with the wrong group given their current infrastructure cost and funding needs? And will this move come back full circle to bite them?” 

Bloomberg is now reporting that oil market analysts are debating if oil will fall to $50. Seems a few weeks prior—because it was—that experts were saying crude could not breach $75. In North Dakota, prices are already there. Crude sold at the wellhead in the Bakken shale region in North Dakota fell to $49.69 a barrel on Nov. 28, according to the marketing arm of Plains All American Pipeline LP. That’s down 47% from this year’s peak in June, and 29% less than the $70.15 paid for Brent, the global benchmark. Many experts know that U.S. shale drilling has changed the playbook for the landscape of energy markets, and OPEC views them as a threat. Since 2006 the United States has cut its net oil imports by 8.7 million barrels per day, which is equal to the combined oil exports of Nigeria and Saudi Arabia.

Abdalla El-Badri, OPEC’s secretary-general, stands firm on his comments that half of all U.S. shale output is vulnerable below $85-$90, and that U.S. oil producers can’t make money with oil prices under $90 a barrel. The reason that analysts and El-Badri are wrong on this is that since 2008, U.S. oil production has gone from five million barrels a day to more than nine million barrels. This $85 to $90 figure is based on the theory of “tight oil.” 

“Tight oil” is generated from fracking because it comes from locations that are difficult to access, such as tight sandstone or shale. With U.S. drillers getting access to “tight oil” this now accounts for most of the growth in the global supply in the last several years. The cost to access these “tight oil” areas differs from others, but the $90 only applies to roughly 20% of all the oil fields in the United States. Business consultancy IHS recently released a study showing that 80% of the tight oil estimated to come out of production in 2015 will still be profitable for U.S. oil producers between $50 and $70 a barrel. 

The reason U.S. producers can sustain where OPEC and non-members cannot is through the technological advances U.S. oil producers have developed. Prior to the last 15 years, normal wells were producing 300 to 400 barrels-per-day, and this has now risen to 500 to 600 barrels-per-day per well when oil companies implement super fracking procedures. Furthermore, Pioneer Natural Resources has stated that it has options through 2016 covering two-thirds of its likely production. 

“We can produce down to $50 a barrel,” says Harold Hamm, of Continental Resources. The International Energy Agency said most of North Dakota’s vast Bakken field “remains profitable at or below $42 per barrel. The break-even price in McKenzie County, the most productive county in the state, is only $28 per barrel.”

But just as the price of production in the United States seems to be giving U.S. producers more breathing room, a current analysis by Citigroup indicates higher “fiscal breakeven” levels for other producers (see “Breakeven,” below). 

The fiscal breakeven price measures the price an oil producing country must get for its oil to produce a balanced budget. The reason their costs are so high vs. U.S. producers is that the governments of these countries have spent the bulk of their profits on subsidizing everything from 5-10¢-per-gallon gasoline to cheap housing that kept a growing population of underemployed citizens content. “What’s your breakeven?,” (below) shows the 2015 estimated breakeven cost for numerous oil-producing countries. 

What’s going to happen to all these players when the price of oil drops 30% or 40%?  Oh, wait, it already has. Plus, if it stays at these levels how will OPEC and others be able to sustain and maintain their own infrastructures? 

Marie-Claire Aoun, director of energy at the French Institute for International Relations in Paris said, “Strong demographic pressure is feeding [OPEC’s] energy and budgetary requirements. The price of crude is paramount for their economies because they have failed to diversify.” 

If oil goes below $50 will this be a black swan event for them, collapsing their own Gross Domestic Product and financialization? Financialization is the mass commodification of debt and debt-based financial instruments collateralized by previously low-risk assets, a pyramiding of risk and speculative gains that is only possible in a massive expansion of low-cost credit and leverage. A cut in income to these countries will have dramatic effects on not only their obligations to their citizens but the loans they’ve taken out that still need to be funded. 

Near-term outlook?  

Greg Sharenow, executive VP of Pacific Investment, told Bloomberg that Canadian oil-sands operators would probably be the first to cut output, followed by operators in newer U.S. shale plays, but that’ll only happen if oil falls another $15-$20 per barrel. It is trading just below $70 in early December 2014. And with Chevron announcing on Dec. 3 that they’ve already begun pumping from their half-billion barrel find in the gulf, and daily production is expected to reach 94,000 barrels of crude, and no one wanting to cut their output across the globe, there can only be one direction for crude to head, which is lower.  

With traders looking for a safe way to trade this market, they could put on a simple 1x2 put/call option spread with a high probability of expiring worthless. By using the following combination, as long as oil stays between $53.21 and $73.00, traders stand to make about $7,500 to $18,000.

  • Buying 10 Feb 71.00 calls/selling 20 Feb 72 calls
  • Buying 10 Feb 56.00 puts/selling 20 Feb 55 puts

The risk/reward model for this position is shown in “Playing a crude range,” (right). If prices do head lower, how long until the members and non-members of OPEC can sustain their current infrastructure needs along with financial liabilities?  Only time will tell.

Tim Fligg is a proprietary trader.

About the Author

Tim Fligg has been a professional trader for more than15 years. He has been profiled in Futures and currently is a proprietary trader focusing on equities, options and futures. He most recently put up the highest return ever on real money, 44.7% within three months, on BattleFin 7.0.