Update on the Oil Crisis: It Is Confusing but Not That Confusing
first published on The Street | Mar 28, 2016

The twists and turns in this oil crisis are fascinating and show why long-term economic prediction is so hard. Pontification on oil prices is at its high, usually a sure sign that nobody knows what they are talking about. And yet the story is far from over.

We know the broad story to date. The price of oil collapsed to below $30 per barrel for Brent Crude in January, having dramatically declined particularly since it was at about $70 in June. Since then, there has been something of a small rally, which may or may not be holding at about $40. Pundits argue first about the reason for the collapse in the price.

It was clearly due to the increased supply or at least perception of ever-increasing supply of oil by the United States and other frackers, as well as a typical failure of cooperation between Organization of the Petroleum Exporting Countries members, in particular the Saudis and Iran as well as Russia. The Saudis reacted by trying to flood the market with more oil rather than lose share.

This was partly to hurt the frackers, as they break even typically at $40 per barrel, versus the Saudis at $20. But this was probably not the only factor in the Saudis’ thinking.

In any event, the whole strategy was only a very partial success. Yes, many frackers slowed down, but many have shown themselves to be nimble at surviving, and as the price of oil gets back to $40, they are back on line again rapidly.

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Recent negotiations between the OPEC members, Iran, Russia and the Saudis seemed to be heralding a determination for all to perhaps cooperate and reduce oil production, at least to get prices back to about $60 per barrel. Hence, the small rally since January.

But how is it possible under these parameters for there to be a sustained oil price rally, at least in the medium term as some have argued? Yes, the frackers are still only a small part of the total global oil supply, at least under the now constrained oil price, with shale just 5 million out of 96 million barrels per day of supply.

But fracking’s share of the market could significantly grow if oil prices were higher, which is what the Saudis feared less than a year ago when they started flooding the market with oil. In any event, there is still global market oversupply of about 1 million to 2 million barrels a day.

Recent oil producer meetings gave the market some hope, but as Saudi oil minister Ali Al-Naimi said last month, oil supply cuts aren’t coming, and he would rather see the market naturally wipe out apparently inefficient oil producers, by which he meant frackers and the Americans. Meanwhile, the Americans are never going to be a party to some kind of forlorn attempt by OPEC to take control again of oil prices.

So actually, perhaps it is simple and generally consistent with standard “oligopoly” and “game” theory. If OPEC, the Saudis, Russia and other countries do materially cut supply and the price went about $40 for even a medium-length time period, the U.S. frackers would be back in action big time, re-asserting their legitimate attempt to end our dependence on Middle Eastern oil.

As this happens, supply increases, OPEC and the Saudis lose market share again and the cycle begins afresh. Prices then must fall or at least stop rising.

Oil prices couldn’t really return to where they were before the new age of fracking arrived a few years ago, i.e., $90 per barrel.

Although fracking is controversial from an environmental perspective, extensive fracking is occurring in the United States, and it hasn’t led to the doomsday predictions of the anti-fracking lobby. Yes, a carbon-global energy economy isn’t ideal, but that is the reality for now.

In any event, even after the Saudis’ incredibly aggressive price-cutting strategy, fracking is clearly too nimble to be disappearing. Some of the more over-levered frackers will fail or are failing, and there will be consolidation in the industry.

But it is an industry and an energy innovation that is here to stay. It will have a permanent dampening effect on oil prices for the foreseeable future, assisted by the utter inability of OPEC members, Russia and other material oil producers to cooperate rationally.

They never cooperated well in the first place. But this inability to behave symbiotically for their mutual benefit is particularly strong when these parties are in shock, as is the case right now.

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Russia faces possible sovereign-debt default at these oil prices, the Saudi deficit is growing as the coffers that used to fill the state-run social welfare system are bleeding dry and Venezuela is close to collapse. Meanwhile, the United States has a far more diversified economy than Russia or the Saudis, so it can afford to fight these price wars for much longer than those other countries.

This “fracking effect,” whether perceived or real, is ultimately good for us all.

It may have wiped out significant value in energy stocks — some $2.3 trillion since 2014 — and that isn’t good, but the value decline is sector-specific and probably not wide enough at least on its own to trigger a huge market correction or recession. But sustained low oil prices are fundamentally a positive, good for most other corporate sectors and consumers, and it is very smart for the West to continue to break its dependence on despotic, corrupt and unstable Middle Eastern regimes.

Finally, the death this month of fracking king Aubrey McClendon, who co-founded Chesapeake Energy, perhaps sends a curiously relevant signal. If he did commit suicide, it will be tragic indeed, as he made a huge contribution to revolutionizing the oil industry and transforming it largely for the benefit and ultimate stability of Western nations and consumers.