The Merriam-Webster dictionary offers this definition for the word capitulate: "to stop fighting an enemy or opponent; to admit that an enemy or opponent has won."
I'm not sure who oil companies are fighting, whether it's oil traders, OPEC, Russia, or some invisible market force, but they're losing. The domestic standard, West Texas Intermediate crude oil, fell below $50 per barrel on Monday , while the global standard, Brent crude oil, passed under the same major barrier on Wednesday.
Who is going to stop the bleeding? OPEC is not cutting production, the U.S. is expected to increase output in 2015, and Russia has little choice but to sell whatever crude oil it can just to make money. But someone will have to capitulate if these players aim to halt the slide in oil prices.
Who is going to blink first?
Depending on who you ask, oil markets are oversupplied by 1 million to 2 million barrels per day. That creates a problem with oil prices because supply and demand are very inelastic, meaning they don't change very much even if prices change dramatically. Think about your own gasoline usage. If prices fall 50% how much more do you drive? Probably not very much.
This inelasticity can cause wild price swings if the market is either undersupplied or oversupplied. With the market currently oversupplied by 1%-2%, prices have dropped rapidly. The only way to fix the problem is to bring supply more in line with demand by lowering oil production.
Normally, it is OPEC's role to lower production when the world is producing too much, but by doing this over the last few decades its global market share has fallen from about 50% in the 1980s to roughly 33% today. It is sick of losing share and is standing firm on keeping production at 30 million barrels per day no matter the price. Saudi Oil Minister Ali Al-Naimi even said the organization would ride out the storm if oil falls to $20 per barrel.
The U.S. isn't helping, either. According to the U.S. Energy Information Administration, U.S. oil producers will add another 720,000 barrels per day to production this year, exacerbating oversupply. Continental Resources (NYSE: CLR) and Linn Energy (OTC:LINEQ) are just two of the companies that have slashed capital spending on new wells in 2015, but that doesn't mean they'll curb production. The most expensive part of an oil well is the initial drilling; once that's done, the cash costs of fracking and production are well below $50 per barrel, so production will go on.
Russia is the other big player in the market and hit a post-Soviet record of 10.667 million barrels per day of production in December. Russia isn't cutting back on production... it's ramping up!
Who this will hurt most
If no one gives in on production, the pain of low oil prices will continue to be felt worldwide. Russia stands to lose as much as $140 billion in 2015 if prices stay low; the EIA predicted OPEC would lose $257 billion, but that was before oil fell below $50 per barrel.
On the stock market, companies such as Continental Resources and Linn Energy, which have used debt to expand drilling, will be in the most trouble. Continental has $5.8 billion in debt on the balance sheet and Linn has a whopping $11.8 billion in debt. Both are spending less on capital expenses this year, but the downside of using debt to fuel expansion is that if credit markets freeze up due to low oil prices or some other situation, companies can face liquidity problems, forcing a sale or even bankruptcy.
The only way I'd play oil markets today is with service providers such as Seadrill, Halliburton, Core Laboratories, or Schlumberger, which are needed no matter where oil is being extracted. They'll find work whether Russia, Saudi Arabia, or the U.S. is drilling for oil.
Betting on individual explorers is more risky because you're betting against entities like OPEC and Russia cutting production. They haven't done so yet, and I'm not willing to bet against them in this battle. Buyer beware when it comes to energy stocks today.