WHERE IS OIL HEADING?

Couple of months ago, I read with interest that Goldman Sachs and Citibank were calling for oil to drop to US$20 per barrel. At that time, oil was trading at US$44 - US$45 per barrel.

Did it happen? No.

Similarly, just before the Global Financial Crisis, Goldman Sachs was calling for oil to reach US$200 per barrel.

Did it happen? No.

If everyone can accurately predict the price of oil and other commodities, then none would require any bailing out by the US Government when the crisis struck.

With oil touching more than US$58 per barrel, we continue to have bearish call that oil will soon drop to US$20 - US$30 because there are more than a thousand wells in the US which can be put on line within weeks. 

Should we fear that oil will fall off the cliff to US$20 - US$30 per barrel? In my opinion, that is unlikely to happen and here are my reasons:

1) When oil started falling many of the US producers said that they were shutting down unprofitable wells to move to profitable ones. The unprofitable wells are mainly due to their geological structure or geographical location. So when oil was at the US$40s range they shut off the unprofitable wells. What makes you think that they might even consider producing from the unprofitable wells when oil is at US$20 - US$30.   

In all likelihood, oil will not reach US$70 or US$80 in the medium term. I anticipate that as soon as oil touches US$60 - US$65 per barrel then producers will increase their production and oil would fall back to the US$50+ per barrel.

2) Fear that Iran will expand its production and add to the global supply. I think the Mideast will remain very volatile. The crisis in Yemen could provide a support for oil. I also believe the negotiations with Iran will drag on. 

3) Shale oil producers are running out of cash. Few ever operate with a profit. Even if you have a low debt to EBITA, without profit how are you ever going to pay off the debt? In recent months several producers have run out of options. There were thousands of layoffs, and many have stopped paying a dividend. Some have opted for bankruptcy protection, the others, sold shares at a heavily discounted price. This is a sign of an industry in distress. So by the end of the year, few producers will survive this crisis.

4) Shale oil wells deplete at a much faster rate than conventional wells. So unless there is additional drilling or discovery of new oil, production will drop off at some point. With less options on financing, and a heavy debt burden. I doubt that many producers could afford to replenish the fall in production.

So in the medium term I think oil will remain in the US$55 - US$65 range. 

But with many cutbacks in explorations, we could see a major oil spike in the next 2 -3 years. Despite what many said that renewable energy will become cheaper and cars become more energy efficient, oil is not just all about energy and cars. Oil is used for an increasing number of consumer goods, and as long as the population expands, there will be demand for oil.

As a mature economy looks at renewables and energy efficiency, another growing economy steps in, and consume more oil than they ever did before.