The following article is courtesy of Marshall Gitler, Head of Investment Research for FXPRIMUS.
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There’s a big mystery in the financial world: why is the output of oil not responding to the fall in the price? A fall in price is a signal that supply exceeds demand. Producers usually respond by cutting back on production. That’s the idea behind Saudi Arabia’s strategy of keeping production high: they want to drive the highest-price producers, the US shale oil drillers, out of business. Then global production will fall, supply and demand will balance again, and the price can go back up.
The conundrum is clear. The number of oil rigs in the US is down almost 70% from the peak and more than 42 oil drilling companies have filed for bankruptcy as the price of oil collapsed.
Yet even with two out of three oil rigs sidelined, production has only come off slightly – and is rising once again. US output last week was down only 4% from the peak.
So the amount of oil that each well is producing has almost tripled, from around 6,200 b/d per well to 18,500 b/d per well.
The reason is that first, producers have shut down their least productive wells and kept pumping their more productive wells. Secondly, technology is coming to the rescue: oil producers are using new techniques and new technology to boost output and keep their wells competitive.
Now there’s some even more dramatic news. Bloomberg Intelligence, an analytical service of Bloomberg News, calculates that some of the shale producers are still profitable with crude prices below $30/bbl, some as low as $22.52/bbl.
Moreover, that’s for wells that are completed. Oil companies have a backlog of over 4,000 wells that have been drilled but haven’t yet been completed. Drilling it is very expensive; once it’s already drilled, finishing it with the above-mentioned new techniques and technology to increase the production isn’t so expensive. Bloomberg Intelligence found that in many areas it’s still economic to complete these wells at oil prices below $30/bbl, in some cases at prices as low as $14/bbl!
The bottom line is that the supply of oil is probably less responsive to low prices than everyone had thought. It’s not likely to bounce back significantly any time soon, unless there is some major disruption to supplies out of the Middle East or OPEC (aka Saudi Arabia) changes tack.
The impact of continued low (or even lower!) oil prices on the FX market would be:
1) The oil currencies – CAD, NOK, MXN, RUB – are likely to continue to come under pressure.
2) The other commodity currencies, such as AUD and NZD, may languish alongside them, although of course they are more correlated with other commodity prices.
3) Global inflation is likely to remain lower for longer than central banks had anticipated. Combined with the recent move by the Bank of Japan into negative interest rates, this means we could be in for another round of competitive interest rate cuts, which in effect means a “currency war.”
4) The big question is, will this low level of global inflation cause the Fed to change its plans? No one can answer that yet. But it needs watching. The “monetary policy divergence” theme is based on the idea that the Fed tightens while the ECB loosens. But if the Fed isn’t tightening, then policy won’t diverge as much as expected and EUR/USD can recover somewhat. And if the Fed were to start loosening too…