What a $20 USD Barrel Means For the US Oil Industry

What a $20 USD Barrel Means For the US Oil Industry

In late 2015, Goldman Sachs, Inc. made a bold prediction that crude oil prices could possibly go as low as $20 per barrel. Goldman does not guarantee oil will hit that price but instead argues the oil industry is entering a period of lower prices for its commodities that could last a while. The company is known for making headline-grabbing statements to garner some attention. Goldman commodity experts argue that changing supply dynamics due to fracking have altered the face of the oil industry. There is no doubt a sustained period of low crude oil and natural gas prices could result in dramatic changes to the U.S. oil industry.

Goldman’s View

Goldman states that only in a worst case scenario would oil hit $20 a barrel. In fact, the bank predicts crude oil prices of around $45 for 2016. Still, it argues a further fall in price is necessary to clear out a substantial supply glut.

The bank believes the shale oil revolution has changed the energy outlook for the United States. Goldman notes that the U.S. imported around half of its crude oil in 2006. Since that time, crude oil imports have fallen as oil fracking production has ramped up. The increasing supply in the U.S. is coming during a period of uncertainty about future economic growth in China. Both of these factors are leading to lower oil prices.

The oil market has entered what Goldman calls an “exploitation phase.” A number of new pipelines have allowed for shale oil to be easily transported to major refineries in the Gulf. This has led to the collapse of the price differential between Brent Crude, used primarily in Europe, and WTI crude. Although global demand for oil continues to grow, new technological advances in shale drilling have caused supply to outpace demand.

This new technology has reduced the cost per barrel for the production of shale oil. When prices were still high, drilling and production companies ramped up output. This was especially true when oil prices were over $105 a barrel in July 2014. Oil companies continued to increase production to take advantage of the high prices. Eventually, the oversupply became a drag on the price. Prices fell to below $40 in August 2015.

Goldman points to a fall in the rig count as prices for oil have declined. Despite less production from lower rig counts, prices continue to fall because the U.S. has too much storage capacity. Goldman states there is enough excess storage capacity in the country to hold a 500,000 barrel-a-day surplus for a year. Tanker capacity for the storage and transport of oil is also very high. The excess storage capacity will keep the country supplied for a while. Thus, oil prices need to drop further to work through this excess storage. Goldman sees oil inventories beginning to decline in the fourth quarter of 2015.

Oil Sector Layoffs

If oil does ever go down to $20 a barrel, there will be massive layoffs in the oil industry. Companies will be forced to dramatically back off on production and reduce their workforces to cut their costs in order to stay solvent. The effects of low oil prices are already evident in the U.S. oil industry in this regard. Companies have been forced to lay off workers due to the low prices during the decline in 2014 and 2015.

It is estimated that companies have cut around 86,000 jobs since June 2014. Oil service providers such as Baker Hughes, Inc. and Halliburton Company have cut around 46,000 jobs alone. The industry is unsure when oil prices may recover. The price volatility in oil makes it difficult for companies to engage in capital planning for future expansion and growth. Thus, new production projects are being put on hold, reducing demand for employees.

The major production companies such as BP plc and Chevron Corporation have avoided layoffs initially. However, continued low prices will eventually force those companies to follow suit.

Oil Company Bankruptcies

Oil prices as low as $20 per barrel would definitely result in a large wave of oil company bankruptcies. Debt levels are already high across the industry with oil hovering around $45 per barrel. The oil industry is necessarily a capital-intensive business. It takes a great deal of infrastructure to produce, transport and sell crude oil. Companies need to issue a large amount of debt to fund this capital development.

With the downtrend in prices, this debt is mounting up. Companies are struggling to service their debts with lower revenues. About 16 oil companies have defaulted on their debts through September 2015. The number of bankruptcies will grow exponentially if oil drops to $20 per barrel.

Smaller companies, especially those in the shale industry, are at much greater risk for bankruptcy than larger companies. They have smaller liquidity cushions to withstand periods of lower oil prices. Many credit rating agencies have downgraded the debt for oil and gas companies. This could lead to a tightening for the amount of credit extended to oil companies. A credit tightening places more pressure on those companies with liquidity issues. Experts predict there will be more bankruptcies coming if oil prices cannot sustain a move above $60 per barrel.

Drop in Rig Count

Crude prices of $20 a barrel will result in further drops in the rig counts for oil production, which has already been occurring down since 2014. Companies will shut down production with lower prices. Rig counts are a trailing indicator for the industry. Rig counts go down as prices drop and vice versa. Many in the industry follow rig counts to provide a glimpse into future production and supply trends. Although production costs vary among companies, the median cost for production of a barrel is around $51. This indicates around 50% of companies are losing money with oil below that level.

The rig count is on a fast decline. It was around 2,350 for North America and the Gulf of Mexico in October 2014. That number dropped to about 975 by October 2015, a reduction of around 58%. This drop in production should eventually support the price due to lower production and inventories. However, the high storage capacity means there is still plenty of supply to draw from; it may take a while for the supply and demand forces to even each other out. Until then, oil companies are forced to wait.