The Oil Price Ceiling Has Been Set: "Above $40 And We Start Pumping Again"

Tyler Durden's picture

Last week we reported that in what has been Saudi Arabia's biggest victory to date in its war against U.S. oil and gas producers, both Whiting Petroleum, which is North Dakota's largest oil producer, and Continental Resources would indefinitely suspend fracking operations for the foreseeable future. The reason was simple: oil prices are too low to make incremental drilling and pumping profitable, and instead most shale companies are now entering hibernation, limiting cash outlays in the form of dividends and capex spending, in hopes of weathering the crude oil storm, which has already gone on far longer than even the most pessimistic mainstream pundits expected it would.

Which, of course, is the right response: as the saying goes the cure for low oil prices is low oil prices, and as more shale companies halt drilling, exploring and production, the 3 mmb/d oversupplied oil market will slowly return to equilibrium.

There is logically a flipside to that as well: as those companies which have recently mothballed operations either voluntarily or because they had to when they went bankrupt when oil was at $30, return to market the previously oversupplied market condition will promptly return as well, thereby pressuring oil lower yet again.

The question is at what "breakeven" price does it make sense for US shale companies to return. As Reuters reports, less than a year ago major shale firms were saying they needed oil above $60 a barrel to produce more; however in just one year this number has changed and quite drastically at that.

We hinted at this three weeks ago in an article which many readers had a hostile reaction to: specifically we warned of "Another Leg Lower In Oil Coming After Many Producers Found To Have Far Lower Breakevens." As we reported then, "what many thought would be the "breaking" price point for virtually every shale play has just been lowered, and quite dramatically at that. It also means that algos and traders who had reflexively bought any dip below $30 on expectations this is close to the "sweet spot" and where the Saudis would relent, will have to drop their support levels by as much as a third."

 

Today Reuters confirms that this assessment was stpo on with a report that some shale companies say they will settle for far less in deciding whether to crank up output after the worst oil price crash in a generation.

Among the companies which are prepared to flip the on switch at a moment's notice are Continental Resources led by billionaire wildcatter Harold Hamm, which said it is prepared to increase capital spending if U.S. crude reaches the low- to mid-$40s range, allowing it to boost 2017 production by more than 10 percent, chief financial official John Hart said last week.

Then there is rival Whiting Petroleum which may have stopped fracking new wells, added it but would "consider completing some of these wells" if oil reached $40 to $45 a barrel, Chairman and CEO Jim Volker told analysts. Less than a year ago, when the company was still in spending mode, Volker said it might deploy more rigs if U.S. crude hit $70."

EOG Chairman Bill Thomas did not say what price would spur EOG to boost output this year, but said it had a "premium inventory" of 3,200 well locations that can yield returns of 30 percent or more with oil at $40.

Apache Corp , forecasts its output will drop by as much as 11 percent this year, but said it would probably manage to match 2015 North American production if oil averaged $45 this year.

The reason for the plunging breakeven price? The same one we suggested on February 3: surging, rapid efficiency improvement which "have turned U.S. shale, initially seen by rivals as a marginal, high cost sector, into a major player - and a thorn in the side of big OPEC producers."

To be sure, while many had expected low oil prices to curb output, virtually nobody had predicted that even a modest jump in oil ($40 is just $7 from here) would lead to a major portion of US shale going back on line.

The threat of a shale rebound is "putting a cap on oil prices," said John Kilduff, partner at Again Capital LLC. "If there's some bullish outlook for demand or the economy, they will try to get ahead of the curve and increase production even sooner."

Which in turn will force the Saudis to immediately retaliate, breach all amusing "production freezes", and double down their efforts to crush shale.

In fact, some producers have already began hedging future production, with prices for 2017 oil trading at near $45 a barrel, which could put a floor under any future production cuts.

Another risk factor for all those hoping the modest rebound in oil will persist is the record backlog of wells that have already been drilled but wait to get fractured to keep oil trapped in shale rocks flowing. There were 945 such wells in North Dakota compared to 585 in mid-2014, when prices peaked, according to the latest available data from the Department of Mineral Resources. Their numbers are growing as firms like Whiting keep drilling, but hold off with fracking.

Reuters' summary:

Their latest comments highlight the industry's remarkable resilience, but also serve as a warning to rivals and traders: a retreat in U.S. oil production that would help ease global oversupply and let prices recover may prove shorter than some may have expected.

Our observation three weeks ago was practically identical: since Saudi Arabia had expected that its FX reserve outflow would last only temporarily using $40-50 breakevens, it will have to sell many more US reserves (either TSYs or stocks) to fund the cash shortfall which will persist for far longer until oil catches down to the lowest cost US producers.

What this means is that for the Saudis to declare victory they will have to unleash a sharp downward oil spike that lasts long to put as many marginal producers out of business as possible.

As we said: "In short: the oil price war is about to enter its far more vicious, and far more lethal phase, and while it is unclear who ultimately wins, whether it is Shale or the Saudis, the loser is clear: anyone who bought into bets of an imminent oil bounce."

But the real punchline has nothing to do with breakeven prices and efficiency and everything to do with balance sheets, because if and when the mass default wave finally hits and hundreds of U.S. corporations undergo debt-for-equity exchanges in which the bondholders end up with the equity keys, then the all-in production costs (AIPCs) will be drastically cut even lower as there will be no interest expense left to cover with operational cash flow proceeds.

As such, the stunning outcome may well be one in which U.S. shale turns Saudi's "marginal producer" war on its head, and unleashes a massive oversupply spike, one which slowly at first then very fast, leads to the Saudi exhaustion of its FX reserves, until it is Saudi Arabia which itself is pushed out of the low-cost production bracket and is instead forced to deal with far less palatable outcomes such as social insurrection and revolution, as its already precarious welfare state fights for survival in a world in which government oil revenues have trickled to a halt.

What happens to the price of oil then is unclear, but what will need to happen before we get to that point is very clear: oil will have to trade far, far lower from its current price.

And even if it doesn't, we now have the oil price ceiling bogey: any time a barrel of crude approaches $40, watch as the "marginal" producers do just that, and resume production on very short notice.

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0b1knob's picture

I hate to break this to you geniuses at Zero Hedge, but:

 

 

The minimum price of oil if $0 for a company struggling to avoid bankruptcy.

The minimum wage is $0 and a LOT of people are earning that right now.

 

The idea that there is some magical equilibrium level for oil is the idee fix of Zero Hedge.  The deflationary maestrom of the Minsky moment is on us.  

TradingIsLifeBrah's picture
TradingIsLifeBrah (not verified) 0b1knob Feb 29, 2016 2:24 PM

Once a well is dug, they just keep pumping it.  It costs money to shut it down, better off to keep running until you can't breakeven at the daily cost level which my guess is somewhere in the single digits for oil companies.  These "costs of production" also don't factor in that all of the O&G suppliers cut their prices as oil prices decline so while it may have cost "$50" to pump oil 2 years ago the cost is much lower because all the equipment suppliers are struggling and cutting prices as well.  

RogerMud's picture

all well and good until Cushing is full ... long swimming pools

MalteseFalcon's picture

Now they can pump at $40 instead of $70?

I thought USA oil was gone in 1975?

Holy Hubbard!

TradingIsLifeBrah's picture
TradingIsLifeBrah (not verified) RogerMud Feb 29, 2016 3:15 PM

All through 2015 we've heard about how the storage was going to be gone "soon".  The reality if you look into it is that no one really knows how much storage is available.  Seems really stupid, I know, but no one ever kept track of it in any single or consolidated database so everything is run off of "estimates" and we all know how reliable those are.  My guess is that storage is likely a lot higher than these estimates make it because there was so much money flowing in oil during the run up years that people probably built a ton of it.  It was covered on ZH once that no one knows what the actual global (or even US) storage capacity is I think in like 2014 but then the stories converted over to just that we are running out.  

MalteseFalcon's picture

America's oil storage ran out in 1975.

We never needed it again.

bbq on whitehouse lawn's picture

Moving product from a large tank to a smaller one doesn't make the product grow.

KnuckleDragger-X's picture

We're still running on rumor from the Saudi's. I don't think it will matter in a few months when the economic numbers can no longer be 'adjusted' into a smiley face......

cowdiddly's picture

Oh goody, then they get to borrow even more money and get into even deeper in debt in the oil drilling ponzi scheme called shale fracking

RawPawg's picture

pennies,steamrollers....

just random thoughts i had popping inside my head.

Dr. Engali's picture

They must have gone to the Sarah Palin school of eCONomics. Drill baby drill!.

Tyrone Shoelaces's picture

I remember that, way back in the 'peak oil' days.

BlueStreet's picture

Their equipment might be rusty beyond repair by the time we get back to $40. S&P 1400 isn't going to get oil to $40. 

lawton2's picture

I dont believe any are truly viable long term below like 55 dollars no matter what spin they put out there to try to make Saudi change their tune.

bbq on whitehouse lawn's picture

Now i see why Goldman forcast $20 as their target. Brakes them all.

TradingIsLifeBrah's picture
TradingIsLifeBrah (not verified) bbq on whitehouse lawn Feb 29, 2016 2:20 PM

Investors are so starved for yield that even at $20 oil most of these companies will be able to either issue equity and/or issue debt to rollover any upcoming debt repayment obligations.  Until the market freeze up this party will keep going.

bbq on whitehouse lawn's picture

Goldman helps with both the selling of equities and debt. More selling is good for Goldmen. Brakeing the companies in the process and rewarding themselves, dont forget the bankruptcy management teams.

TradingIsLifeBrah's picture
TradingIsLifeBrah (not verified) Feb 29, 2016 2:18 PM

Only $7 to go (Crude at $33) until we can reach a recovery.  Yes We Can!

ghostzapper's picture

Wow, thank god.  This is great news.  Since the financial media cheerleaders are always accurate and correct once this baby gets back above $40 I can get out there again peddling High Yield Shale Bonds yielding a massive 4.99% at par.  The assumptions built in are quite reaosnable oil just needs to hold above $40 in 2016 and then rocket above $100 in 2017 holding at least at that level for twenty years to cap total capital losses at only 30%.  I'm really anticipating strong interest in these debt instruments.  

Hohum's picture

Bluff.  Huge (yuge) bluff.

Lemmings For All's picture

I try to pump only when her price is below 40 bucks.

Winston Churchill's picture

Don't you get a drip when its so cheap ?

freakscene's picture

Here in Western PA, I've noticed no slow down at all this winter at Shale sites.

 

Actually, they continue to expand. I watched two new pads get built on my way to work, and the pads that are already built are crazy busy with trucks.

 

shortonoil's picture

"The price of oil depends on the strength of the economy, and the strength of the economy depends on oil's ability to power it."

The Hill's Group

MSimon's picture

These guys:

 

http://www.manhattan-institute.org/pdf/eper_16.pdf

 

Say shale production costs could go to $5 to $20 a bbl. Equivalent to Saudi production costs.