Oil, Oil, Toil and Trouble [Update]

Further to our series on falling oil prices, the Dow Jones average closed down about 300 points today, finishing its worst week in more than two years. The usual buzz has it that the fall in oil prices is responsible for this slump. But falling oil prices ought to be a net plus for the economy as a whole and should be good for stocks overall in the long run, even if the energy sector gets battered for a while. There may be some question marks for banks that have lent too heavily to undercapitalized energy companies, and there may be some question marks for some transport sector companies, but other sectors should see near term improvements in profitability that should raise their stock prices.  (Unless you think the market as a whole is overvalued, which is a reasonable hypothesis at current valuations.)

But Wall Street doesn’t like surprises and uncertainty, and when there is uncertainty and surprise, lots of asset managers move to cash and sit on the sidelines to let things shake out rather than rotate straightaway to the sectors like retail, chemicals, autos, and airlines that will be obvious winners from cheaper oil. And before very long, some energy companies may be compelling buys. I’m starting a watch list.

I decided to reach out to the CEO of a very successful private oil exploration company for his inside opinion, and this is what he tells Power Line:

Our Rate of Return (ROR) drops to 10% on our wells at $55 oil.  However, this assumption assumes no drop in costs to drill wells and no contraction in the large differential ($10 to $12 per barrel) between Bakken and WTI oil.  In reality our ROR would actually be above 10% at $55 WTI oil price as our costs to drill would also come down.  There are plenty of drilling locations that would have above 10% ROR at $40 oil.  Even more drilling locations would require $70, $80, or $90 oil prices for that ROR.  Of course, drilling will slow down long before you get down to a 10% ROR.  Most will want at least a 20% ROR.  Of course the quality of the operator matters in addition to the drilling location. . .

Bottom line is that the Saudis want to chill investment in new oil supply to help protect OPEC’s future.  In round numbers we have had about 5 MBOPD increase in world oil demand over the last 5 or 6 years.  Over the same time period US oil production has grown from nearly 4 MBOPD (from 5 to 9 MBOPD) — 80% of the increase in WORLD demand!  This is NOT good for OPEC.  I suspect that we will have ugly oil prices ($60 – $75) for around a year as that is long enough to stop many current oil supply investments and, more importantly, serve to chill the appetite for future large investments in oil supply growth (deep water, arctic, marginal shale, marginal tar sands, etc) which is the Saudi goal in my opinion.  I do not believe that the current price ($65) is a sustainable price going forward.  It would not encourage enough new supply to balance world demand which itself would be goosed upwards with the lower prices.  I suspect that after this ugly price period ends, we likely see oil bouncing around the $75 to $95 range or something like that.

Of course all of this depends on the state of world economy which has many significant challenges such as at the required unwind, or more likely significant revamping, of the unsustainable entitlement states over the next two decades.  I personally believe that the Euro currency was a very bad idea from the start and is damaging for Europe and unsustainable as an institution.  The unwind of the Euro within the next 5 or 10 years could also cause significant economic headwinds for the world economy.