Oil Crisis Explained In 3 Minutes

This article was first published in December 2014.

We’ve seen oil plummet from over $100 per barrel to nearly $50 in the span of a few months. During that time, we’ve read a lot of things about OPEC, shale, the Russian Ruble and junk bonds. How does it all fit together and where do we go from here?

I’ve been compiling some information in this space, so I’d like to present it here to give context to the selloff. Let’s try to make this short and sweet (or sour, depending on your portfolio). It may be a strong dose of reality, so put down the coffee if it’s still hot.

Let’s start from the beginning.

West Texas Intermediate Crude Oil Futures, January 2015 (aka “oil prices”). Source: TradingView

Oil prices have crashed. West Texas Intermediate (WTI) Crude Oil, the market benchmark for oil prices in the USA, has gotten crushed. And it caught a lot of people flat-footed. This Bloomberg article consolidates a lot of bullish analyst comments, including this one from Goldman, published just 2 months ago.

Source: Bloomberg.

A bottom of $80? Good luck with that. With Brent already at $60 per barrel, the forecast was certainly off. Here’s another one:

Source: Bloomberg.

Ouch! If Goldman and Barclays were wrong, you certainly shouldn’t feel so bad about having a few USO holdings underwater. But let’s get back to business. What drove the selloff?

First Blow: Supply.

Everything seemed fine. The economy was coasting. Unemployment was down. Sure, P/E ratios were a little stretched, but earnings are rising! And the Yellen put was in play. Naturally, oil prices should keep rising with rising demand.

Not so fast. If you take a closer look at supply, things have been fundamentally changing. Take a look at US oil production over time:

Source: EIA.gov. http://www.eia.gov/dnav/pet/pet_crd_crpdn_adc_mbbl_m.htm

Expressed in annual terms, US oil production has jumped 50% in 2 years from a steady 2 billion barrels to 3 billion between 2011 and 2013. Where’s all the supply coming from?

The short answer is shale. Technological improvements in drilling have enabled access to previously difficult-to-reach reserves in many parts of the US and abroad. In particular, drillers can now easily extract oil from shale. When supply goes up, prices come down. And prices did.

The Sucker Punch: OPEC does not come to the rescue.

Then came the curve ball. What usually happens when oil prices drop so quickly is that OPEC steps in and saves the day. (OPEC is an “Organization of Petroleum Exporting Countries” that traditionally works as a cartel to control oil prices to their benefit.) The logic goes like this: OPEC wants higher oil prices so they can sell at a higher price. So when prices fall, they usually come together to cut supply in unison. But this time, they refused to do so.

As oil continued to plummet, OPEC made a public statement that basically went like this:

“Too bad. Deal with it.”

This caught a lot of traders and investors flat-footed, as they (we) largely expected OPEC to intervene. Heck, I bought some oil, too. And it continued to plummet, breaking $70 per barrel.

Drillers getting drilled

By refusing to intervene, OPEC exacerbated the oil price collapse. And many drillers that were counting on high oil prices would now be bleeding money. This chart shows the minimum breakeven price for oil for producers focusing on various oil assets:

Source: Citi. Via Business Insider. http://www.businessinsider.com/citi-breakeven-oil-production-prices-2014-11

What does this show? Basically that a lot of new drilling ventures that were banking on shale exploration are going to lose money as oil drops below $60 per barrel. Their entire operations will be unprofitable. Note that the prices shown above are for Brent Crude Oil, which generally trades at a $5-$15 premium to WTI Crude.

OPEC Is Driving Drillers Out of Business

By refusing to cut production, OPEC can now drive out excess competition in the market. The idea is that this will reduce total production, at least temporarily, and allow prices to recover so OPEC can resume selling at a higher price. Clever, no?

Wait, but that’s not fair!

Too bad!

Repercussions in Russia

Russia’s economy is widely dependent on oil. Some have said that Russia is an energy corporation disguised as a country. The oil price drop really hurts Russia, which was already at high risk of recession in 2015 after suffering from European sanctions in response to conflicts in the Ukraine.

As the energy crisis took shape, the Russian Ruble proceeded to crash last week as investors pulled money out. Russia scrambled to aggressively raise interest rates by a whopping 6.5% to drive money back in, but that wasn’t enough.

Source: Google Finance

As a result, the Russian currency has dropped to record lows (above). Russia is in a tough position, as President Putin acknowledges.

Source: Bloomberg. http://www.bloomberg.com/news/2014-12-19/oil-rebounds-from-5-year-low-as-market-most-volatile-since-2011.html

High Yield Getting Crushed

Another market that’s visibly shaken is the high yield debt market. As oil production accelerated in recent years, drillers financed much of their new ventures with debt. Prices on these debt securities have come down significantly, as evidenced by the High Yield Bond ETF (HYG).

Source: TradingView.

And that shouldn’t be a surprise. A quick look at the breakdown in holdings in HYG reveals that the second largest sector is Oil & Gas. As drilling ventures lose grasp of profitability, they’ll start to delay debt payments, eventually tripping covenants and defaulting altogether. It’s the beginning of the end.

Source: iShares. http://www.ishares.com/us/products/239565/ishares-iboxx-high-yield-corporate-bond-etf

What’s Next?

While OPEC refuses to cut supply, we will have to wait for production to consolidate in the US to drive a bottom in oil prices. The following quote from today should be either enlightening or heartbreaking:

Source: Bloomberg. http://www.bloomberg.com/news/2014-12-19/oil-rebounds-from-5-year-low-as-market-most-volatile-since-2011.html
“Three months.”

Side story: I somehow got put on an accredited investor cold call list and was receiving a half a dozen calls per week from oil joint ventures that were raising money, particularly for drilling and exploration. These drillers were all “conservatively” underwriting their returns based on $85 per barrel prices. After the oil crash, the calls have completely stopped.

Additional resources: Howard Marks Gives Crystal Clear Explanation Of How Oil Prices Work

Special thanks Frank Cannova, Ryan Ortega and Kevin Yu for insights and input.

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