A weekly look at what occurred in the oil markets of the U.S. and the world this past week and what’s ahead.
When the price of oil first began declining in fall 2014 under the weight of increased supply from the U.S. shale fields, the news media covering this historic decline kept looking for that one magic number – what was the cost of production in the shale?
The idea behind the question was that at a certain point, if the costs of production were more than the price, shale wells would need to be shut and the freefall in prices would slow. It was a perfectly legitimate question and the answer that regularly came back was always somewhere in the $75-$80 range. By March 16, when the price of WTI had dropped to less than $30/barrel, it was a sign that those estimates were probably inaccurate (or that hedging programs put into effect at higher prices were doing exactly what they were intended to do – protect the producing companies against big declines in price).
The off-the-cuff estimates on the current average cost of production in shale is obviously a lot less than those figures from almost five years ago. And this past week, the Dallas Federal Reserve Board said if you want to know what that cost of production is, just go look at the futures curve for WTI on CME.
“In theory, if the oil market were perfectly competitive, the long-dated futures price should equal the marginal cost of supply – the cost of producing one additional unit – needed to meet long-run demand,” the Dallas Fed writes in its report.
That long-dated value is easy to find. It’s published every day by the CME on this page. But the Dallas Fed, when it talks about long dated futures, isn’t talking six months out. It’s talking 10 years. The fact is the chart at the link doesn’t have a figure 10 years out but there is one almost nine years. The settlement for the February 2028 WTI contract on CME Thursday was $52.56/barrel. That is significantly below a WTI price that until the declines of the past week had been solidly above $60/barrel since early April.
The Dallas Fed report notes that at any given time, there are plenty of outside factors that can distort the oil market from some sort of perfect economic balance. It notes the presence of OPEC and its decision to either add or withdraw supply from the market. “Nonetheless, there is still good reason to believe the long-dated futures price will have a close connection with the marginal cost of supply,” the report said.
As the Dallas Fed notes, the cost of production has a rapid impact on oil supplies, far more than more conventional drilling ever did. Shale production is largely geologically risk-free; the drillers know where the shale is, they know there are hydrocarbons in it and they can produce them quickly. But if the price they can get for what comes out of the ground falls below the marginal cost of production, they can rapidly cut back their activities. And conversely, when the price rises, they can bring it back on just as quickly. “Shale has a shorter lead time between drilling and production relative to offshore exploration and other traditional oil projects, making it more responsive to oil price movements,” the Dallas Fed report says.
But the Dallas Fed doesn’t simply look at the long-dated price as the end-all of its work. It does extensive surveys in the field. The latest survey that was published this past week puts the breakeven price of oil at $50/barrel, down $2/barrel in the last year. But that is an average. Within the Permian Basin, for example, the Midland and Delaware basins have significantly lower prices. And not all companies are alike. For example, the Dallas Fed reported that even in the Permian Basin, “individual responses to the most recent survey ranged from $23 to $70.”
The cost curve is also flatter. And that means that spikes in price that get the market nervous may tend to be short-lived. “[T]here is a much larger amount of supply that can be called into action given a much smaller price increase than in the past,” the Dallas Fed report said.
Put that all together and it’s good news for an industry like trucking that has fuel as one of its major cost centers. There might be “major oil price movements…but it does point to a strong tendency that oil prices will be range-bound in the near future,” the report says.
Oil markets plummeted this week with prices now back to where they were in early March. The bevy of geopolitical issues that were supposed to keep the market marching higher have fizzled out and now it’s nothing but bearish news – including the U.S.-China trade war – that is setting the tone for oil prices.
One aspect that is particularly unique to diesel is the fact that farmers are having significant problems getting into the field to do planting in areas hit by heavy unceasing rain and the flooding that often goes with it. Additionally, some inland waterways are closed to traffic until waters recede, further reducing demand for shipping. For example, the Arkansas River is closed to barge traffic until at least June 1 as is the port of St. Louis, according to Petroleum Argus. It also reported that various locks and dams on the upper Mississippi River are closed. Even if farmers could get out into the field, barges bringing fertilizer might not be able to get to local ports to supply those farmers’ needs. All of that negatively affects demand for diesel.
If distillate inventories – which includes diesel – are growing in the U.S. Midwest as a result of these travails, there aren’t any signs of it yet in inventory figures. The weekly Energy Information Administration (EIA) report for the region known as PADD 2, which includes the Midwest, did not show any significant change in diesel inventories in the report issued last week. But price reporting agencies are reporting that the spread between diesel prices in that region and the benchmark CME ultra low sulfur diesel (ULSD) price is showing a growing weak market in that part of the country. And the national figure for “product supplied” – a proxy for demand – in the latest EIA report showed total distillate product supplies down more than 200,000 barrels per day (b/d) from the prior week, to the fourth-lowest weekly figure this year. It all shapes up to a picture of a diesel market that is hardly on the verge of some pre-IMO 2020 surge any time soon.
(The chart below shows the wholesale rack price of ULSD at Des Moines, Iowa, in the heart of the corn belt, against the national average wholesale rack ULSD price in SONAR. Des Moines so far is not yet showing weakness beyond the national drop in prices.)