Recently, however, it has become clear that OPEC’s strategy has backfired and that the low oil prices of 2015 only caused the domestic frackers to become more efficient in order to survive. Driven primarily by innovation and investment in technology, domestic frackers have quickly and drastically driven down their break-even cost of production to levels that are profitable even in a low oil price environment. Frackers have quickly developed improved “cocktails” of water and chemicals to vastly improve yield, invented ways to increase well pressure to drive out more oil, and adopted technology (e.g., drones that are able to replace certain laborers) to cut costs. As a result, frackers’ average break-even price fell by over 40% from early 2016 to approximately $40/bbl. in early 2017. In certain areas, the average breakeven price is lower. For example, the average break-even price in the Bakken shale formation (North Dakota and Montana) is close to $30.*
As newly efficient domestic frackers reenter a market where capital remains cheap, the growth in the global supply of oil will eventually begin to outpace the growth in demand. While supply is expected to remain in check for the remainder of 2017, the International Energy Agency has predicted that oversupply will begin to accumulate in the market in 2018. Non-OPEC producers are expected to increase production by 1.5 million barrels per day, while global demand is only expected to increase by 1.4 million barrels per day. The market is beginning to anticipate this oversupply, leading to a year-to-date oil price decline of ~20%. While global oil demand has generally remained constant, a decline in demand in response to global growth falling short of expectations as a result of, for example, lower than expected fiscal stimulus in the US, could put additional downward pressure on the price of oil.
The effect of a low oil price will have short- and long-term ramifications on various asset classes. In the short term, commodities and high-yield debt will likely come under the most pressure. The price of oil itself is a large component of a broad basket commodity indices; thus, commodity index funds may decline in value. Additionally, the high-yield debt market (comprised of a high percentage of energy companies) will likely experience spread widening and potential defaults. As we do not see these energy market dynamics reversing in the short term, we reiterate our neutral/underweight posture in high-yield debt and lower our posture in commodities from neutral to neutral/ underweight.
Over the long-term, a prolonged low oil price environment may have destabilizing consequences for the global economy because many nations rely on selling oil to generate national revenue. However, many of these countries assume a higher than market oil price to balance budgets as illustrated below. Russia, for example, has assumed a $72 price of oil to balance its budget for 2017. As a result, countries will likely increase production to generate revenue necessary to fund national operations, further increasing supply.