Why oil prices are headed lower

Oil prices may have steadied over the weekend at around US$43 a barrel, but the ongoing supply glut is likely to continue and could even get worse.

Evidence of that is a report by the UK’s Telegraph last month. Scott Sheffield, the ex-CEO of Pioneer Natural Resources – a North American shale-oil and gas driller – has told the paper that his pre-tax production costs in the Permian Basin of West Texas have fallen to US$2.25 a barrel.

Definitely we can compete with anything that Saudi Arabia has. We have the best rock,” he says.

Any hopes Saudi Arabia and OPEC (Organisation of the Petroleum Exporting Countries) had of outlasting US shale producers during a short period of lower oil prices has well and truly been dashed.

Continuing improvements in hydraulic fracturing, drilling technology and data analytics means shale oil and gas drillers in the US can compete at oil prices the vast majority were expected to go broke at.

Additionally, productivity improvements mean drillers don’t have to drill as many wells as they used too. According to the Telegraph, the decline rate of production over the first fourth months of each well was 90% a decade ago for US companies. In 2012 it had dropped to 31% in 2012 but is now 18%. Shale drillers have found ways to get more oil out of each well over a longer period. That helps to cut costs too.

It also means that any recovery in oil prices will see more shale drillers re-enter the market, keeping oil prices low. The only oil projects that appear to be dropping out of the supply side are those enormously costly deep water wells. The economics for many of those potential new oil supplies will have been severely damaged.

That also presents a problem for Australia’s oil and LNG companies like Santos Ltd (ASX: STO), Woodside Petroleum Limited (ASX: WPL) and Origin Energy Limited (ASX: ORG). LNG prices are linked to oil prices but are highly secretive and well-guarded. At some stage, lower oil prices are going to impact on their LNG contracted revenues.

Foolish takeaway

We may not see oil prices below US$30 a barrel, but we could certainly see sub-US$40 a barrel in the short term. Great news for motorists – not so great news for oil companies and their shareholders.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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