Oil price bounce

Oil price bounce. But can oil prices sustain; most likely not!

The good news for oil drillers is that oil prices have risen 26% in the last month. But the bad news is that oil prices are still 50% below their June 2014 levels. In a nutshell, oil is awfully volatile and nobody has a clue as to what will happen. For example, Goldman Sachs has a target of $30/barrel while the OPEC has an estimate of $200/barrel. The price may settle somewhere in between, or so we hope!

The apparent reason for the crash

Ask anyone the reason for the crash in oil prices and you will hear two points: US Shale and OPEC supply. They are right, but the truth is that both these were the indicators rather than the real reason for the crash in oil prices. The real reason may be something more structural, something more fundamental and has to do with the way oil companies the world over are financed and run. And that is not great news!

It is all about balance sheets…

If you want to understand the real reason for the oil price crash, look at the balance sheet of energy companies. Let us look at the US companies. US energy borrowings increased 4-fold from $200 billion to $800 billion between 2003 and 2014. During the same period, the total debt of US corporate sector increased from $2 trillion to $6 trillion. In a nutshell, the rise in energy company debt had outpaced overall debt and now accounted for close to 14% of overall debt. That is surely a worrying scenario.

A higher debt meant consistently higher prices to service them and also to protect the value of the collateral. When prices started falling, the only solution was to sustain higher output to compensate for the price cut. That meant selling more oil in the futures market which added to the pressure on spot prices. Hence the crash!

What about global oil supply?

Global oil supply has been at its highest. The reasons are once again related to the US dollar. Over the last year the dollar has strengthened against most currencies. A strong dollar makes it more difficult for foreign firms to pay off their dollar debt. This has forced them to raise output to make up for their dollar servicing.

The road ahead…

Goldman may be closer to the mark as the dollar continues to strengthen. This will force global oil companies to pump more oil to service their dollar debt. And as US companies struggle with their debt, energy companies will pump more oil and sell more oil futures. Don’t read too much into this bounce-back. It may be a dead-cat bounce. Companies are caught in a debt/supply trap. Till then, oil prices will continue to stay low!

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