Cheap Oil, the Dollar, and Deflation

I want to shift gears a little today and open a discussion on some of the wider economic implications of a lower oil price.  The motivation behind this post is a discussion I had with a close friend, a former investment banker who currently works as a corporate strategist for an international oil company.  I mentioned to him how I believed that a lower oil price would almost certainly have deflationary, or at least have disinflationary consequences.  My friend, who is an inflationist, countered with the counterintuitive argument that if lower energy prices stimulate spending in other areas, that spending could result in demand pull inflation.  At the time I wasn't in a position to argue, but his point was not lost on me, so I went home to examine whatever data I could find on the subject.

Correlation between oil price and deflation in past oil price spikes and crashes:

Last week's oil price crash was not unprecedented, and examining past oil price crashes is likely to provide some historical insight.  Recent oil price drops occurred in 1981, 1985, 1997, 2000, and of course 2008.  The price drops of 1997, 2000, and 2008 can be attributed to demand shocks associated with the Asian financial crisis, bursting of the technology bubble, and global financial crisis respectively, whereas the 1985 oil price crash was due to a supply glut after Saudi Arabia flooded the global oil market.  Finally, the 1981 price crash was a combination of oversupply and the early 1980's recession triggered by major interest rate hikes specifically targeting inflation.

In all of these cases lower oil prices led to lower inflation, and even deflation, in the following years as seen in the figures below:

Long term real oil price (www.macrotrends.net)

Long term United States CPI (www.inflation.eu)

When looking at these figures, it's extremely important to acknowledge that in cases where the oil price drops were brought about by recessions it is impossible to attribute disinflationary or deflationary effects to the fall in the oil price.  This leaves the oil price crash of 1985 as the only comparable precedent.  Interestingly, it can be observed in this case that disinflationary effects were short lived.

Disinflationary mechanisms associated with a lower oil price

There are a number of fundamental reasons that we should expect a lower oil price to lead to deflation, at least in the short term.  Chief among those is the impact of the price of oil on the US dollar, as a strong US dollar reduces the price of imported goods and services.  In spite of the recent resurgence in US oil production, the US is still a significant petroleum importer.  As such, the US runs a large petroleum trade deficit, which is US dollar negative.  However, as shown in the following figures, this deficit is shrinking and will continue to shrink, and perhaps even turn to a surplus, due to both lower oil prices and increased US oil production.  This is immensely bullish for the US dollar.

Furthermore, energy, and particularly oil, is an important input to cost of many goods and services.  If the price of oil remains low, we should expect to see some cost savings work it's way back to the US consumer.  In fact, we are already seeing the impact on prices as illustrated by the CPI, and my preferred method of measuring inflation, the BPP index (Billion prices project).  The BPP is perhaps the broadest and most unbiased measure of inflation available, as it measures prices by scraping the internet for prices from hundreds of online retailers.

BPP Daily Index (bpp.mit.edu)

BPP Monthly Inflation (bpp.mit.edu)

Demand Pull Inflation

The crux of my friends argument was that lower oil prices would stimulate spending in other areas, leading to demand pull inflation.  Based on the 1985 precedent, where inflation rebounded quickly after initially falling, the data may actually be on his side.  The arguments against demand pull inflation revolve around consumer deleveraging and economic slack.  If consumers choose to pay back debt instead of spend their petroleum savings, we would not expect demand pull inflation.  Furthermore, if there is enough economic slack to absorb additional demand, the demand pull inflation argument also becomes less compelling.

Measures of household debt appear to be returning to early 2000 levels seen in the chart below.  Although household leverage appears to be stabilizing, there is still some room for leverage levels to decrease further.

Household Debt as a % of Disposable Income (Seeking Alpha via Economics Fanatic)

On the other hand, indicators of economic slack appear to be in line with long term historical levels.  Most of the slack created during the 2008 recession appears to have already been absorbed as shown below:

Indicators of Economic Slack (Wall Street Journal)

With data on household deleveraging mostly inconclusive and data on economic slack showing historically normal levels of slack, it appears that demand pull inflation may in fact be a possibility if consumers spend their petroleum savings.

Conclusions and Investment Implications

It appears my friend has a compelling case for demand pull inflation in the medium-long term. However, in the short term, the US dollar is likely to continue to strengthen and long dated US treasuries may outperform as they will benefit from the current deflationary environment.  That deflationary environment may be short lived due the possibility of "demand pull" inflation, where US consumers spend their petroleum savings on other goods and services.  If this is the case, US treasuries may not be such a good investment in the longer term. It is important therefore to keep a close eye on indicators such as the US trade deficit, household debt, and measures of economic slack.  Personally, I find it difficult to take a position here either way, as timing bond and currency markets is not my strong suit.

OPEC’s miscalculation and the shifting oil supply cost curve

I made my bearish case for oil about a year and a half ago, and so far it appears to be playing out.  This post is a follow up to my prior writing on the subject, given new information since the time of my previous posts.  I now believe the low oil price environment we are now in will persist for some time, and that the price of oil may even slide further.  The reasons behind my current thinking can be summarized as follows:

•   OPEC’s very existence has been threatened by the shale oil revolution because
•  Technology improvements continue to drive down costs in shale oil with the result that
• The oil supply cost curve has shifted downward and flattened allowing for
•  Companies active in oil shale drilling in the US to continue to grow and take share from OPEC even in a depressed oil price environment, the outcome being
• The stabilizing force of OPEC on oil prices will be removed from the market leading to
• Oil prices dropping to the marginal supply cost, which may be as low as $40/barrel for infill wells in established shale plays.

OPEC’s dilemma

The US shale revolution has increased global oil supplies and is cutting deeply into OPECs market share.   In the last 5 years, OPEC’s share has dropped from 41% to below 38%.  While this may not seem like much, the downward trend in share should be alarming to OPEC.  If share dips into the low to mid 30% range, OPEC’s ability to influence global oil prices would be greatly diminished. OPEC’s recent decision not to cut production quotas is a direct response to this threat, and is specifically targeted at US shale production.  It is my belief that OPEC’s actions will ultimately prove futile, and that market share losses will continue.  This belief is based on technological improvements in shale oil production in addition to the fact that oil shale players should be able to continue to increase production at lower prices without further exploration by drilling sweet spots in established plays.

Technology improvements driving both cost and productivity

A number of technological factors have contributed to increasing productivity of shale oil wells and lower unit costs.  These factors include:

Greater fracture consistency:  Fracture techniques have evolved to allow for more targeted, consistent fracks.  An example would be a migration to ball-drop fracks from plug and perf.  An illustration showing the results obtained from improvements in fracture technology provided here. 

Increasing fracture density: With more consistent fracks, oil companies have been able to increase the number of frack stages for a given horizontal well length.  Where a company may have previously employed a 15-stage fracture along a 1-mile horizontal well, they may now have 30 fracture stages.  The additional fracture stages come at a marginal increase in cost and allow significantly more reservoir to be accessed from the same well.  A detailed discussion on frack density is provided here. 

Longer horizontals: Oil producers are also drilling longer wells then they ever had before, made possible by improvements in horizontal drilling technology.  Longer horizontal wells allow for more of a shale reservoir to be accessed from a single well.  A detailed discussion on the horizontal well technology improvements is provided here. 

Pad drilling: Producers are increasingly shifting to pad drilling, which involves drilling multiple wells from a single location.  Pad drilling allows for minimal surface disruption  and fewer rig moves, which significantly reduces costs.  Pad drilling is discussed in depth here.

All of these factors improve productivity and reduce unit costs.  In fact, many companies have increased their type curves by 25-40% in just the past year as discussed below.

US shale companies are raising their type curves

The way to best illustrate the impact that improving technology is having on cost and productivity in oil shale plays is through production type curves.  A type curve is simply a visualization of the production for a typical well in a given hydrocarbon bearing formation over time.  As companies employ more advanced technologies and improve their drilling and completion techniques, production type curves have increased significantly in virtually every single basin.  In the past year, oil companies have been proudly discussing the improvements they have made to their type curves as shown in the screenshots from various company investor presentations below.

EOG - Eagle Ford

EOG - Leonard

Devon - Cana-Woodford

Devon - Bone Spring

Continental - Permian

It’s important to note that it’s not just one company in one basin that is increasing their type curve; it’s virtually all companies in all basins.  Furthermore, both the magnitude and the consistency of the increases have been incredible.  There are companies that have increased their type curve by 20% a year for each of the past 3-4 years with little increase to normalized drilling and completion costs.  This implies unit costs per barrel are falling nearly as fast.

Supply cost curve continuing to shift 

New discoveries and cost improvements in shale oil drilling have led to a major shift in the oil supply cost curve, as illustrated in the chart below (Goldman Sachs via ZeroHedge).

Goldman’s analysis shows full cycle break even costs around $80 for most US shale production, however more recent data from Citi shows even lower break evens in the $60-$70 range (Citi via BusinessInsider). 

Note that these costs are for full field, lifecycle development, which includes land acquisition, exploration, facilities, and infrastructure development.  Break evens for individual wells in established shale plays are lower still, and in a declining oil price environment it’s the break evens for these infill wells as opposed to new field development that matter as companies will shift from exploration to drilling in sweet spots in established areas.  Unfortunately, I don't have data to share here as individual well economic data tends to be closely guarded.

OPEC’s miscalculation

It appears that OPEC’s belief is that US oil producers will be forced to reduce production at oil prices below $70-80, however this is not the case.  While it’s true that most US shale plays have breakeven points above $70, breakeven costs are trending downward.  Furthermore, those breakeven points are based on full cycle development costs, which includes acquiring land, exploration, unlocking the geology by experimenting with different completion methods, and building new roads and facilities in green field areas.  However, a tremendous amount of new oil has already been found in US shale plays in recent years, and much of the infrastructure required to develop it has already been built.

The breakeven point for drilling an infill well in an existing play is MUCH lower than $70, and many oil shale companies have built incredibly deep inventories of infill drilling locations.  What will happen with oil prices below $70 is that oil firms will shift from exploratory drilling to focusing on drilling their best locations in existing fields.  Because of sheer depth of drilling inventory that shale oil companies have accumulated, the production associated with this infill drilling will still be enough to keep US oil production growing in a low oil price environment.

What this means for OPEC is that the decision to pursue maintain production levels in the face of declining oil prices will not have the desired effect of driving out US production and increasing market share.  This will become evident in the months and years ahead as we will likely see US oil production continue to grow in the face of declining prices. 

Long-term implications for the price of oil

For the reasons stated above, I believe the price of oil will continue to fall and remain depressed for many years to come.  Based on falling half cycle development costs in US shale plays, I would expect a long term trading range for oil between $40-$60US.  The prediction assumes that oil demand continues to grow at a moderate place.  Dips below $40 may be possible if we find ourselves in a recession.

Most oil and gas production companies should still be shorts, and oil service companies will be hit even harder.  This is a long-term call.  In the medium-term, especially bearish sentiment at the moment could perhaps set up a short-lived bounce, but I am not a market timer.  My original short “oil services” call was about 6 months early, but has resulted in significant profits to date.