In practice, there is no bottom to how low oil prices can drop: as Canada's Bank of Montreal calculated over the weekend [7], as a result of an unsustainable supply-demand balance "something has to give", and for that to happen oil may drop to $25, $20 or even $15, as some aggressive put buyers are speculating [8]. This is what the Canadian bank said:
We believe that the weakness in crude oil prices reflects a combination of fundamental factors and financial flows. Fundamentally there is simply too much oil.
Could oil prices collapse to $20?
The short answer is ‘yes.’ We believe that crude oil prices could fall further unless global oil production is reduced. We estimate that the global oil market could be oversupplied by roughly 920,000 bpd in 2016. The key assumptions are year-over-year growth in global demand of 1.2 million bpd, Saudi Arabia, Iraq and Libya hold production at current levels, Iran ramps up production at moderate pace over the course of the year and the U.S. rig count remains at current levels. This would translate to a build in global crude oil inventories of roughly 231 million barrels over the course of the year and potentially result in OECD crude oil inventories reaching capacity by the end of the year.
In theory, however, imploding crude prices, while distinctly probable in the near-term in order to flush out all "pent up" fundamental and financial excesses, will likely revert for several reasons, chief of which is that as we approach the production price floor in an environment where marginal funding for drillers is now practically non-existent, the long overdue series of corporate defaults will ultimately result in much of the marginal production going away (if only for the time being - a simple debt for equity swap means the assets can still perform even as the liabilities are restructured).
That, however, is just the beginning.
Here, again via BMO, are the various oil price floors which make any short-term oil plunge very likely but a long-term oil price collapse not practical.
Where is the floor price for oil?
We believe that the sustainable floor price for oil is a Brent price in the range of $30-35/bbl. Oil prices could temporarily fall below that level; however, companies would begin to shut-in production as variable production costs would exceed cash flow for some projects. Cash operating costs vary materially depending on the type of development, as shown in Chart 30. There are also additional expenses such as cash taxes and interest payments that represent incremental cash costs that vary by company and must be paid out of cash flow. It is also worth noting that the revenue generated for any type of play varies depending on the quality of the oil being produced and its location. For example, in situ oil sands receive a price that is currently $16/bbl less than the price of Brent. That means at Brent prices of $30-35/bbl, in situ oil sands operations on average are not generating enough revenue to cost their cash costs. Companies that rely on trucking and rail are exposed to significant transportation costs that could effectively decrease cash flows by $10-20/bbl. Western Canadian conventional heavy oil producers often incur relatively high trucking costs to transport production. In prior oil price downturns, this was some of the first production to get shut-in.
[9]
What oil price is required to sustain production?
We believe that the industry requires a Brent crude oil price in the range of $40-50/bbl in order to sustain production at current levels as shown in Chart 32. Again the level of sustaining capital varies depending on the type of resource. For example, for in situ oil sands operators, sustaining capital is roughly $6/bbl whereas sustaining capital for a conventional onshore oil play is approximately $15/bbl and for shale oil we estimate that sustaining capital is approximately $18/bbl. Accordingly, at Brent prices below $50/bbl we would expect global non-OPEC oil production to decline over time, recognizing that there would be an initial lag.
[10]
What oil price is required to encourage new investment?
In order for the industry to grow oil production and deliver a return on capital, we estimate that a Brent crude oil price of $60-70/bbl is required, as shown in Chart 33. We estimate that on average shale oil developments and in situ oil sands projects require a Brent crude oil price of $50-60/bbl to deliver a 10% return on capital. However, averages can be somewhat misleading as many North American shale oil and oil sands projects achieve cost of capital returns at Brent crude oil prices below $50/bbl.
Ironically, just like with forcing a central bank "put" in the form of QE or more easing, the way to get to these modestly higher "floor prices" is by sending the price of oil to even lower lows from here, a move which will precipitate and accelerate the inevitable consolidation in the oil industry. The longer oil drifts lower at a leisurely pace, the lower it will ultimately end up.
