This Massive "Crunch" Means Higher Oil Prices

This Massive “Crunch” Means Higher Oil Prices

by | published February 24th, 2015

As oil prices inch forward, there’s an inevitable consequence of lower prices building that will help them climb even higher.

It’s called the “reserve crunch.”

Faced with significantly lower oil prices, the replenishment of oil reserves is beginning to take a massive hit.

In fact, Royal Dutch Shell (NYSE: RDS-A) recently reported that it had replaced just 25% of its 2014 production. That’s just 300 million barrels of new reserves to replace 1.2 billion barrels of production.

Now you know why I call it a “crunch.” It’s yet another sign of shrinking future production.

Shell isn’t the only one. Other operators large and small have begun to issue similar statements.

Now in today’s environment of surpluses, it’s hardly surprising that forward-looking production may take a hit. After all, there’s very little reason to continue producing excessive amounts of crude if it’s merely going to depress the price.

But this is the kind of crunch that promises to have a big impact on both crude oil prices and stock valuations…

Oil Prices: The Impact of Falling Reserves

Of course, the impact of the crunch on oil prices is obvious and easy to understand. Any uptick in demand will result in a disproportionate rise in prices for oil futures contracts – especially as rates of replenishment fall.

As for its impact on stock valuations, it’s actually the “booked reserves” – oil in the ground and readily extractable – that influences what investors will pay for a stock.

Companies do not drill for new oil simply to add to the product flow for the refining of oil products. They also drill to add to their booked reserves, boosting their share price in the process.

Typically, the more reserves a company has, the more it can command in the stock market. Conversely, falling reserves usually depresses the price.

Now you might think that in times of excess supply, the reserves on a company’s books may be less of an advantage. But that’s just not the case this time.

Here’s why: Demand is not dropping. That’s especially true during this time of year.

Once again, it’s useful to remember that today’s low prices were caused by too much supply, not too little demand. It’s the demand side of this equation that will keep oil prices from falling much further.

In fact, this is the period when we begin to see a run up of prices in advance of the primary driving season.

For instance, take a look what is happening with gasoline prices.

While West Texas Intermediate (WTI) has climbed nearly 11% over the past month, futures prices for RBOB (“Reformated Blendstock for Oxygenate Blending,” the gasoline futures contract traded on the NYMEX) have raced ahead by more than 25%.

And just this morning, the continuing conflict in Libya has closed Sarir, the nation’s largest oil field. That follows earlier interruptions of the primary pipelines, along with other port and production facilities.

As a result, Brent has spiked again in London, given the more direct influence MENA (Middle East North Africa) events have on the European market. As of noon today, WTI is up 1% and Brent is up 1.2%. Meanwhile, Brent has doubled the increase of WTI for the month, climbing 24% versus the 11% increase in WTI.

Higher Oil Prices Ahead

Against this volatile backdrop, the overall condition of global reserves places an even greater pressure on oil prices. It’s true, WTI can rely on more secure U.S. reserves. But on the other hand, Brent is very sensitive to the availability of worldwide reserves.

Remember, Brent is used as the benchmark for far more actual oil consignments internationally than WTI. The increasing lack of reserves outside the U.S., therefore, is likely to result in the expansion of the Brent-WTI spread.

This pricing difference has favored Brent for all trading sessions except three since the middle of August 2010. The reserve crunch means that spread will now be increasing again.

Several years ago, declining reserves would have been ammunition for the “Peak Oil” crowd that was always quick to point out the signs that we were running out of crude.

Today, falling reserve figures have morphed into something quite different. Yes, oil is a finite resource. But the advent of huge (and increasing) reserves of extractable unconventional oil (shale, tight, oil sands, ultra-heavy) found in regions across the globe has significantly muted the “sky is falling” approach to crude.

This has become an issue of new price ranges. But not one where $200 a barrel is in the offering. The reserve replenishment situation will be rebalanced along with supply and demand.

But with one caveat…

As the reserve crunch worsens, it will introduce another factor that will help to put a floor under oil prices. It will take the market longer to address the falling reserve balance, especially going into a period of heavier use.

That combined with continuing geopolitical uncertainty (now a market staple, not an outlier or exception to the rule) produces one overriding conclusion.

Despite ample options on the supply side, oil prices are stabilizing and will continue to move up.

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  1. Mike Holly
    February 24th, 2015 at 17:18 | #1

    Very misleading article. Solar and wind are heavily subsidized, in addition to requiring a CHEAP battery breakthrough. Nuclear is not cheap due to high capital costs. Ethanol is much cheaper than biodiesel.

  2. Ed Doan
    February 24th, 2015 at 21:55 | #2

    No offense, Kent, but you just guess, too. I think oil will go up in the late spring and summer, but we don’t agree on why. Your comment on gasoline going up faster than oil has more to do with reineries maintaining margins and changing the mix. The cold gripping the north has many still dependent on heating oil and that change in mix made gasoline more scarce and bumped the price, the same reason diesel has remained so high compared to gasoline. Higer demand in spring and summer combined with higher usage at low prices will drive it up in the short term and falling production will pump it up in the latter part of the year. Regardless, we are living it’s future now and can no longer depend on it staying up.

    The reduction in capex and well count of firms will take at least a quarter, maybe two to effect production. I am even more confused over you comments on reserves, as I know of no companies that drill and then idle wells, although that might make sense in the long run. They are more likely to pump anyway if they can make anything at all to help the bottom line against sunk costs. I also think that we get too focused on current production and ignore the effect of the fairly large decline in production of most shale wells and how many were drilled in such a small time period.

    We also seem to have different agendas for America. You seem to favor exporting oil and I find that foolish and short sided if we wish to gain and maintain any form of energy independence. It is a matter of making oil companies wealthy at the expense of us staying self supporting. Why would we ever export a single barrel of oil if we needed to import it to make up for our demand? The world of energy is changing fast and it may make sense in a few years and probably time to exit energy as a holding at all, or at least oil. Nat gas may be our savior as we need electric power more than anything else and have an excess of it for a long time.

    I think you totally underestimate the impact of electric vehicles and the not to distant effect on demand of gasoline. I see a lot of hybrides now and electric plug ins are announced everywhere. Almost silently, China became the world leader in sales of electrics last year and started in the cellar at the start of the year. Our world on everything is one of exponentials and it will be no different in plug in vehicles. If you severly reduce the demand from autos, there isn’t a lot left for oil demand. Diesels are converting as fast as possible to nat gas and there isn’t much left but the airline industry. We are rapidly moving from a dependency on oil to nat gas in almost everything.

    Even solar benefits, as the batteries developed for cars ane now seen as storage devices for them to make power available at night. It will lighten the load on the power grid and make power available for the boom in autos that need it.

    About two years ago, I decided to exit my oil holdings in 10 years, but I have now decided it is more like in 4 years from now and will exit when oil recovers, and it will, to give me a good exit point. We somehow went from peak oil, to too much oil, and technology is rapidly taking us to a point where oil will no longer be relevant. It had to happen anyway, as we don’t have enough in the world with all methods to sustain our demand for long and will eventually run out anyway.

    I am now seventy and have seen oil booms and busts, worked at a service station in JR High and HS with gas at 30 cents, and was lucky to benefit on oil stocks through the years, but I don’t resist change and don’t see it as a long term holding anymore. Our angst over it is too early, but it is no longer a good long term bet, either.

  3. alex
    February 27th, 2015 at 21:09 | #3

    Ed makes many fine points but we must remember that Ed is looking longer term out to 10 thru 100 years and our dear Dr. is magnificent in in accessment from 1 day to 1 year. I am happy to read both a long and short view of good old oil!!! THANKS TO BOTH OF YOU!

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