Here's Why Oil Prices Are Crashing Again
Business + Economy

Here's Why Oil Prices Are Crashing Again

Lucy Nicholson

Third quarter earnings reports are starting to trickle in and the numbers will likely be poor. BP (NYSE: BP) kicked things off on October 27, reporting that its profits fell by 40 percent compared to the third quarter in 2014, but they were also up $500 million from Q2 2015.

BP said that it is planning on oil remaining at $60 per barrel through 2017 and that it would align its operations to fit that assumption. The British oil giant also once again cut its spending plans, with expectations that capital expenditure will drop to $19 billion in 2015, then down to $17 to $19 billion per year through 2017. A year ago, the company had planned on spending $24 to $26 billion in 2015. BP expects to achieve $10 billion in divestment by the end of this year, plus an additional $3 to $5 billion in divestment in 2016, and $2 to $3 billion annually thereafter. The vision reflects a plan to significantly shrink its footprint over the next few years, recognizing the fact that it is overstretched in a low oil price environment. Despite the considerable decline in profits, BP beat analysts’ estimates.

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The Wall Street Journal reported that the four largest oil companies in the world – BP (NYSE: BP), ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX), and Royal Dutch Shell (NYSE: RDS.A) – had a combined cash flow deficit of $20 billion in the first six months of 2015. All four have plans to bring spending down sufficiently so that revenues cover capex and dividends, but it may take a few years. The emphasis on spending, with promises not to touch dividends, suggests that a large number of planned investments won’t move forward. The WSJ says that cuts in spending have led to the postponement of projects that would ultimately yield 7.3 billion barrels of oil equivalent. BP’s CEO Bob Dudley told the Financial Times that the company was deferring an investment decision on the Mad Dog offshore project in the Gulf of Mexico until next year, for instance. 

While the oil majors can muddle through for a while, offshore drillers are already cutting dividends. Noble Corp. (NYSE: NE) announced on October 23 a decision to cut its dividend by more than half. Precision Drilling (NYSE: PDS) will probably beforced to cut its dividend, according to Scotiabank.

In other negative news for E&P companies, Maersk Oil, a Danish oil company and subsidiary of A.P. Møller-Maersk (OTCPK:AMKAF), announced a decision to cut its workforce by 10 to 12 percent. Maersk operates in the North Sea, a region beset with high production costs.

The negative news from across the industry is a reflection of the poor pricing exhibited in the third quarter. Oil prices careened downwards this summer after jumping to $60 per barrel in June, staying below $50 per barrel for much of the third quarter. Oil prices sunk again over the past week on growing fears that the glut is not abating as quickly as once hoped. WTI dipped below $44 per barrel on October 27, and Brent was down to $47 per barrel.

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In a further sign of weakness, contango has returned to the oil markets, a phenomenon in which front month futures prices are much cheaper than longer-term contracts. The pricing quirk develops due to a glut of supplies today, with the expectation that markets will tighten at some point in the future. The contango for WTI is the largest since May 2015, widening after a rapid increase in crude storage levels. The EIA reported last week that crude inventories jumped by 8 million barrels, highlighting the ongoing glut in supply. WTI for December delivery is now discounted by 95 cents relative to January contracts, the widest discount in five months. A contango situation may sound like arcane financial jargon, but it is a persuasive signal of abundant short-term supply.

Rising storage levels contributed to increased bearish sentiment in the oil markets. Speculators shorted oil at the highest rate since July, rising by 18 percent for the week ending on October 20, according to new data from the U.S. Commodity Futures Trading Commission. “The decline in U.S. drilling and production is not enough to rebalance even the U.S. market, let alone the global market,” Citi Futures Perspective analyst Tim Evans told Bloomberg in an interview. “How much do you really want to pay for the next million barrels of inventory you don’t need?”

Natural gas prices are also crashing, dropping to their lowest levels since 2012. NYMEX prices dropped by nearly 10 percent on October 26 alone, dipping below $2.10 per million Btu. That was the largest decline in a single day in almost two years. During intraday trading on October 27, natural gas prices fell below $2/MMBtu, a threshold not breached in over two and a half years.

The sudden collapse in natural gas prices stems from the record production of natural gas in 2014 and 2015. Natural gas inventories now stand 4.5 percentabove the five-year average. The latest catalyst, however, was forecasts for mild temperatures expected across the U.S. in the next few weeks, raising the possibility of much lower demand than anticipated. An El Nino weather pattern could cut into heating demand this winter. Low natural gas prices will compound the headaches for E&P companies already reeling from low oil prices.

Meanwhile, China’s central bank slashed interest rates once again, an unexpected move that buoyed emerging markets. The Shanghai Composite rose to its highest level in two months, following a volatile summer meltdown that spread worldwide concerns about the stability of global financial markets. On the heels of the U.S. Federal Reserve’s decision to postpone a rate hike in September, the rate cut in China has provided further stimulus to emerging market equities. Crude markets welcome loose monetary policy, particularly from the world’s two largest oil importers.

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