Despite roller coaster ride, oil prices will stay low

With oil prices unlikely to rebound from their steep slide anytime soon, producers all around the world will have to scramble to adjust. U.S. shale drillers are slashing their costs to remain competitive, while OPEC and other big oil exporters are looking for a new strategy to cope with cheap oil, now that they can no longer force prices up by restricting output.

Lately, the oil market has felt like a roller coaster: soaring one moment, plunging the next. But pretty much no one is betting on the price of a barrel of crude returning to $100, the level that had come to seem “normal” until recently. We’re expecting the U.S. benchmark, West Texas Intermediate crude, to average between $45 and $55 per barrel next year. If that pans out, expect to see some big changes in the resurgent U.S. oil industry.

American oil production is already starting to slide because of the price drop. And further cutbacks are all but certain in coming months. According to the latest data from the Department of Energy, crude oil production peaked in April at 9.6 million barrels per day. That’s nearly double the level in 2005, before the combination of hydraulic fracturing and horizontal drilling allowed drillers to tap huge deposits of previously unreachable shale oil. But since April, output has slipped to about 9.3 million barrels per day, according to Uncle Sam’s latest monthly numbers.

The decline is no surprise. According to drilling services provider Baker Hughes, the number of rigs actively drilling for oil in the U.S. is down by 60% from a year ago, when the price slump was just beginning. Wells that may have been quite profitable at $100 per barrel suddenly weren’t worth drilling when the price of crude dipped below $45. So, as older shale wells dry up (something they tend to do quickly), fewer new ones have come on line to make up for the lost output.

But the production boom isn’t over. It’s simply on hold until producers figure out how to cope with the new, low-price environment. Here’s why:

Productivity Push

If a return to high prices isn’t imminent, drillers will have to cut their way to profitability. Drilling wells in shale fields is expensive. So expensive, in fact, that many oil market analysts have long assumed that a sustained price drop would wipe out shale operators in areas such as North Dakota and Texas. But so far, that hasn’t happened. The incentive of low oil prices is pushing drillers to cut costs wherever possible, which has allowed more of them to at least weather the current downturn. Even at today’s price of less than $50 per barrel, many of them can turn a profit.

The cost-cutting drive is just getting started. One Houston-based oil industry consultant, who agreed to speak with Kiplinger’s Energy Alert anonymously, says that drillers increasingly see working in shale as an industrial process, one that can be done faster and for less money. Given how well-explored many of the big shale fields are, he says, “you know there’s oil there.” Now it’s just a matter of getting as much of it as possible, as cheaply as possible.

Call it “shale 2.0.” The name of the game is drilling wells faster, with less down time between jobs to minimize costs, while concentrating on the richest oil deposits and using rigs best suited to that particular geology. Equipment makers are designing drills and other gear based on direct feedback from producers about what works best in a given shale reservoir. Drillers such as Hess, a major producer in North Dakota’s Bakken Shale, liken this approach to the concept of lean manufacturing that Toyota popularized decades ago. (Hess even sent executives to Japan in recent years to study Toyota’s approach to optimizing every step of their manufacturing process.)

The bottom line: more oil from each new well. In its latest Drilling Productivity Report, the Department of Energy estimates that producers in the largest shale plays will extract significantly more crude from a newly drilled well this October than they did last October. In North Dakota’s Bakken field and the Eagle Ford Shale of Texas, those gains are on the order of 50% more. That will cushion the blow from falling rig counts, allowing overall production to decline only slightly despite the sharp drop in the number of rigs working.

Of course, cost cutting has its downsides. Employment in shale country is already suffering and won’t bounce back anytime soon. Running fewer rigs and drilling wells faster means fewer workers are needed to produce a barrel of crude. In Louisiana, which produces a modest amount of oil and hosts many companies that supply drillers in other states, the push to pump more with less is costing jobs, says Ragan Dickens, director of communications for the Louisiana Oil & Gas Association. Much of the talk in the Pelican State centers on “who’s merging next?” and “who’s bankrupting now?” he says.

Wally Drangmeister, director of communications for the New Mexico Oil & Gas Association, echoes those sentiments. The state’s rig count has dropped from 100 to 50 recently, and each of those rigs typically employs about 50 workers. Employees who remain on the job are finding themselves in “spirited negotiations” with drillers over their pay, he says. Odds are, many of the jobs being lost now won’t return, even when oil prices rise. Producers that have figured out how to get by with lower head counts won’t be eager to surrender those cost savings.

The Global Picture

So, what happens to U.S. oil output from here? Odds favor a slight dip, and then a resumption of output growth, as rising production from new wells starts to offset the effect of fewer rigs operating. Demand for refined fuel is strong, meaning drillers will have a market for their crude if they can find a way to pump it profitably.

The U.S. will remain the top producer of petroleum, which includes crude oil and related hydrocarbon liquids such as ethane and butane. Output won’t fall enough to allow number two producer Russia or number three Saudi Arabia to overtake the U.S.

Major oil exporters in the Middle East and elsewhere are in a pickle. Historically, when faced with a major price drop, OPEC would dial back production to tighten the market and put a floor under prices. But now, the cartel seems unable or unwilling to act. To really give prices a lift, the group would have to cut production by about 2 million barrels per day. But cutting back by that much would just open the door to U.S. shale producers, who have shown they can ramp up output very quickly when oil prices are high. Moreover, any OPEC member who honors a production cutback has to worry about its colleagues cheating on the deal to grab market share.

So, despite the low price, expect most major exporters to keep the taps open in a bid to maintain their share of the global oil market and earn what revenue they can. The International Energy Agency expects that global oil output will rise by 1.1 million barrels per day this year, even as prolific shale production in the U.S. starts to falter. That trend should continue, especially with Iran likely to ramp up its output now that U.S. and European governments are preparing to loosen their sanctions on Tehran’s oil exports. Thus, oil will continue to pile up in storage around the world, helping to keep prices in check, much to the chagrin of OPEC and oil exporters everywhere.

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The winners and losers of low gasoline prices

U.S. drivers are no doubt cheering on the drop in gas prices, which began this summer and looks set to continue into autumn. But makers of small, fuel efficient cars are paying the price as car shoppers worry less about gas mileage. That spells deals for those buyers who still appreciate a good gas miser.

Fuel Efficiency on Sale

At $2.39 per gallon of regular unleaded, the national average price of gasoline is already well off its summer peak. And as demand eases and refiners switch to making cheaper winter blends of fuel, more and more drivers should start seeing prices that begin with a 1 instead of a 2. The average pump price in South Carolina is already down to $1.97 per gallon, and other states should slip beneath the $2-per-gallon threshold soon.

Cheaper gas is great for consumers, and it should lend some support to the overall economy because drivers who save at the pump have more cash left over to spend on everything else. But one thing they’re not buying: Small cars.

That’s a real reversal from several years ago, when gas prices spiked as high as $4 per gallon and compact, fuel efficient models were all the rage. Manufacturers responded by rolling out higher-quality compacts with snazzy styling, plush interiors and new electronic amenities that let buyers downsize their rides without feeling that they were settling for less car. The age of the big SUV seemed to be over.

Then along came 2014 and the rout in oil markets that sent gas prices as low as $2 per gallon by early 2015. Sales of big SUVs and pickups, which had already been trending up as the economy showed signs of improvement, shifted into higher gear. While not exactly thrifty, those big rigs do get significantly better mileage than their predecessors of several years ago. And with gas nearing $2 per gallon, the cost of fueling up a new Ford F-150 or Jeep Grand Cherokee doesn’t seem so daunting anymore.

The latest monthly auto sales data tell the story. Motor Intelligence, a provider of auto data and analysis, shows that sales of all cars in August were down about 10% from the same month a year ago. Sales of small cars were down 13.5%. Pickup trucks, by contrast, logged a year-over-year gain of about 8%. SUVs were up a whopping 11%, with gains being fueled by sales of new, smaller models (which don’t use as much gas as their full-size cousins but can’t compete with conventional compact cars on mileage).

That spells bargains for car shoppers seeking good mileage. Granted, many buyers need the towing ability or cargo payload of a full-size truck or SUV, and thus won’t care how good a deal they might get on a fuel-sipping compact. But folks who don’t have heavy loads to haul and want to compound the benefit of today’s cheap gas by using less of it should have plenty to choose from.

Late summer always brings sales to dealer lots as manufacturers sell off their remaining inventory to make way for the next model year autos, which tend to arrive in fall. This year, says car shopping website Edmunds.com, some of the best deals should be on fuel efficient models that were already struggling to get off car lots and are due for major overhauls.

They include the 2015 Chevy Volt plug-in hybrid and the 2015 Toyota Prius, both of which will be heavily updated for 2016. Also going for a discount: Honda’s fuel-sipping 2015 Civic and the 2015 BMW 3 series, which is a powerful car but also nets up to 36 miles per gallon on the highway for gas-powered versions and up to 45 mpg for diesel.

Discounts on these and other models will vary by region, since different dealers have differing levels of inventory that need to go. But the potential savings are substantial. Edmunds calls the 2015 Chevy Volt a “steal,” with discounts of almost $4,000. The 2015 Prius is being marked down by about $3,000.

What to Expect Next from Gas Prices

Speaking of saving at the pump, where do gas prices go from here? With Labor Day and the summer travel season behind us, gasoline demand figures to fall a bit at the same time that refineries stop producing summer-blend fuel (a variant that suppresses smog in the warm months and costs more to produce). And with oil prices largely stagnant, look for further price declines at the pump.

The question is, How much more of a drop in gasoline prices can drivers expect? If the price of crude oil continues to hover around the mid-$40 per barrel, we will look for the national average price of regular unleaded to fall 20¢ or so per gallon, into the neighborhood of $2.20 per gallon.

But another tick down in oil prices can’t be ruled out. If it occurs, gasoline could hit its lowest prices since early 2009. Should crude dip well below $40 per barrel this fall, it wouldn’t be surprising to see the national average gas price fall well below $2 per gallon. That would be even lower than the lows plumbed early last winter, when the average fell to about $2 per gallon. By comparison, when the U.S. economy was diving into a deep recession in late 2008, gas fell to as low as $1.61 per gallon on average.

Odds are we won’t see prices fall quite so far as they did during the last recession. But don’t be surprised if they come within shouting distance sometime this autumn.