The price of oil has been on a wild ride for the past year. However, for most of May and June the price of crude was rather stable at about $60 per barrel. Driving this stability was the steadily falling U.S. rig count, which suggested that oil production in the U.S. was heading for a decline. It also didn't hurt that global oil demand was showing signs of accelerating. Unfortunately, that stability was shattered this week after the price of oil plunged 7.7% on Monday marking its worst day in months.
It was a plunge that hinted that maybe the oil industry hasn't fixed all of its problems just yet. Further, it instilled fear among investors that oil prices could be primed for another leg down, with some suggesting that oil could retest its lows from earlier in the year. With uncertainty regaining its stranglehold on the oil market here's a look at where oil prices might go next.
The bear case
The slide in crude oil over the past week was mainly fueled by global growth worries. Greece's rejection of the bailout terms and China's nearly unrelenting stock market slide had many investors worried that the global economy is about to hit the skids. That slowdown would most certainly impact crude oil demand, which is just starting to accelerate.
If that wasn't enough, also putting downward pressure on oil is the potential for stronger than expected crude oil supplies. Not only is Iran closer to reentering the global oil market, but U.S. shale producers have been surprisingly resilient. Some producers are even starting to increase capital spending to push production higher than earlier projections as costs have come down so far that additional wells are now economically attractive.
Pioneer Natural Resources (NYSE:PXD) is one of a handful of companies that is now accelerating its spending after it closed the sale of its Eagle Ford Shale midstream business. Pioneer Natural Resources is expected to net $930 million after taxes from that sale and plans to reinvest those proceeds into new wells. The company is currently operating a dozen drilling rigs in the Permian Basin, but will use that cash to add two more rigs per month for the remainder of the year. While those rigs won't add to Pioneer Natural Resources' production until 2016, the forward looking market sees added production from companies accelerating their production having the potential to keep the oversupplied market out of balance even longer, which could push oil prices even lower.
The bull case
While those are very valid concerns, it's also quite possible that the market is overreacting. The global economic worries could fail to materialize if Greece and its creditors can work out a deal. Meanwhile, China's stock market slide might not destabilize the entire global economy nor its demand for oil as some fear. Further, even if Iran is allowed back into the world oil export market it could be years before its back at full capacity.
In addition to that, not all U.S. oil producers are in the same position as Pioneer Natural Resources where they can easily expand oil production. Many of the weaker shale drillers are likely to have trouble even maintaining their current production rate next year as the production decline rate from shale wells is very steep. That forces these companies to invest all of their cash flow, and more, into new wells.
The problem with this is that it is becoming tougher to do as oil prices remain week. First of all, many shale drillers are running dangerously close to going bankrupt so they don't have the ability to borrow money to drill new wells. Not only that, but most oil companies only hedge their oil production out for a year or two. As those hedges begin to fall off it will leave more of their production fully exposed to lower oil prices, which will push cash flow lower leaving less available to be reinvested into new wells. This suggests that oil production in the U.S. could become harder to maintain the longer oil prices remain low, which is actually bullish for oil prices as a higher price is needed so that weaker oil companies can even maintain production in many cases.
In all honesty oil prices could go either way. If China's oil demand does start to crumble then it could take the price of oil down with it. That's really the biggest risk to oil prices right now. That said, if China's problems don't grow worse and its stock market begins to rebound it could lead to a rather quick rebound in the price of oil. Further, not all oil companies will be able to boost production like Pioneer Natural Resources can as many will struggle just to maintain it. All that to say, the short-term outlook is very murky.
However, the longer term outlook hasn't really changed. Growing demand from emerging economies when combined with persistently declining legacy oil fields suggests that the price of oil will need to be high enough to justify new investments by profit seeking oil companies. So, while oil prices will likely be very volatile in the short-term, the longer term oil price needs to be high enough for oil companies to profitably drill enough wells to keep production flowing and growing.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.