There’s been a strange consequence in the drop in the price of oil that not many people are talking about – increased oil production. Oil production is continuing to rise even as the price falls which on the surface doesn’t make any sense, so it’s a good thing we brought our superman rated x-ray goggles!
It’s bad enough that US shale companies’ margins have been destroyed by the fall in the price of oil but when you throw in the fact that these are the most heavily indebted companies in the US you start to see the big picture. They need good cash flow to sustain their operations and keep their credit rating high enough to obtain loans in the future to pay off existing debt. So they make up a loss in revenues from the drop in oil price through increased production. They can do this because although the cost of drilling a new well is high the cost of extracting oil from existing wells is still well below the WTI price of $45. Maybe the overall cost per barrel is above the current price but that doesn’t matter because these companies are trying to outlast their competitors.
Unfortunately, their competitors are not just limited to other shale companies but entire countries. And these countries aren’t in much better shape than the shale oil companies. They too depend on oil revenues to sustain their way of life. So they too will produce more as the price declines.
What this leads to is a downward spiral in the price of oil. As the price falls, countries and companies desperate for cash are forced to produce more and more in order to stay alive. So oil hasn’t bottomed out yet and it won’t until we see a massive reduction in supply due to bankruptcies in the capital intensive portion of the energy sector.
I am and remain heavily short US energy companies. I’ve been increasing my short position in XLE since the start of the year and will continue to do so. I haven’t been this bearish on a sector since Russian equities in October… and we all know how that turned out.