Overproduction leads to pain in oil market

Written by Gary Silverman, CFP®

Last week we briefly looked at the give-and-take between the good and bad economic effects of these very low oil prices. I ended with a statement that generally economists calculate that the good eventually outweighs the bad. So, at least on an economist’s spreadsheet, oil at $30 a barrel and lower is desirable.

This would be an extremely short-sighted view. Consider this: How good do you consider a company if they put their profits before their employees, their customers, and the environment? Not so good, right? Same with the economy. It’s not just the bottom line—it’s how you get to that line.

I’ll admit that I blame quite a bit of this on the very producers who are getting slammed in the pocket book today. And while I assign blame, I also do not think it is their fault. This is because what is reasonable for the individual company may be unreasonable for an industry. Sure, an OPEC-like cartel might have been able to put an artificial cap on production. But minus some sort of collusion among U.S. producers, the kind of overshoot in production capabilities was bound to happen.

You see, though I know little about the oil business, it stands to reason that if an oil company’s spreadsheet shows that they’ll be profitable by drilling a well, then they drill the well. While the demand remains strong good profits will be made and existing firms might add capacity while new firms, anticipating the loads of money to be made, enter the business. Eventually this ramp up in supply capability will overcome demand and prices will fall.

At that point there would likely be some scale-back in production and prices would stabilize at some “reasonable” level. But this time, the economics of the oil field slammed into the economics of China. If you looked at the chart of oil imports by China, you could confuse it with a picture of the stock market and swear you were looking at the crash of 2008. That’s how dramatically the imports fell; and with it the price of crude.

All that said, I want to come back to the effects of all this. Jobs are being lost, companies are going bankrupt. As this continues, not only the weak and foolish will fall, but we’ll likely see solid, experienced companies be overcome—for this is not your normal cycle but rather one of those events that often gets called a black swan.

While the economists’ spreadsheets may say this is, overall, good for the economy, I think they should be cautious. The next time demand rises there will be fewer players left to meet the need. Those that are there will be more cautious than they were this time. Banks and investors will be less likely to want to loan money to build capacity. Students who were looking at getting into the oil business are already shifting their majors. All that to say: When the world, and especially our economy, needs oil to operate, who will be there to help us?

This article was published in the Wichita Falls Times Record News on March 20, 2016