Crude oil has broken the critical level of $40 and now the price target of $35 is very much insight. The question is why this has happened and if there is any stop to this? The answer is very simple, curb the supply and tie the demand and you will have a stable price. But, in reality, we do not have any signs of this, as both the OPEC and Non OPEC producers are biting for their market share.
The foundation of the U.S. shale oil industry was established on two elements. Firstly, the boom in oil prices, which we experienced in the last couple of years, brought many opportunistic players in the market. These players saw that there were high margins for them and they borrowed with both hands to invest in the U.S. shale oil business. However, those sunny days with rosy price levels are long gone and with oil price getting more whipped, producer’s profit margins are getting squeezed even further- if there is any! So for them, the only possibility is to become more efficient, if they want to stay in the game and this requires more investment.
Secondly, cheaper borrowing rates encouraged these market players to invest heavily in this industry. Currently, we are experiencing a decade of low interest rates and ostensibly the Fed doesn’t want to leave interest rates at this level for much longer. The debate is heating up every day that the U.S. Federal Reserve will lift the interest rate and September is still a sturdy candidate for this.
So, the question is, what this means for those who are investing or invested in the U.S. shale industry? They have surely borrowed at ultra-low interest rates and this has been the main ingredient in their cost recipe, but if those rates are going to go higher, can such players last?
The Fed was really aggressive only a couple of weeks ago to increase the interest rate. However, last week, the FOMC minutes removed the oil stability paragraph from the statement and if this is under looked by the market participants, it will be an astounding mistake. The Fed is increasingly becoming worried about the stability of the oil price. Given where the prices are heading and have also broken the level of $40, top notch- efficient technology will even struggle and it will demand more investment. But, if the Fed does increase the interest rates, the borrowing cost will rise for the U.S. shale oil producers and this is not a healthy situation for the producers.
What we are expecting now is that the rig count numbers could fall in the coming weeks as the Baker Hugh rig count numbers are slightly lagging. The slight bounce which we experienced recently was based on the price when it jumped above the $55 level and the speculations were anchored that the crude price could hit the $80 level soon. But, now the situation has changed completely, and as long as the price stays below the $40, we strongly contemplate that rig number will drop. This will dent the US shale oil supply and crude oil could see a bounce on the back of this in the next quarter or so.
If the oil price does stabilize after the bounce, this would interpret less qualm in the market and hence, the Fed will be back on track in raising the interest rates. The reason is simple because surging oil price will also aid the inflation which is a major pillar for the Fed rate hike decision. Therefore, if we do see the price of oil back in the 55-65 dollar range, the Fed could spark their desired twenty five basis point rate hike by the end of this year. In return, this will prop up the borrowing cost for the US shale oil producers and as a result, we could see the supply glut evaporating further by the first quarter of next year. By mid next year, the price of oil could very well be near the $80 while the Fed continues their path of hiking the interest rate.
Disclosure & Disclaimer:The above is for informational purposes only and NOT to be construed as specific trading advice. responsibility for trade decisions is solely with the reader.
by Naeem Aslam