Predicting near-term fluctuations in commodity prices is a mug’s game — as anyone mugged by oil’s decline from $102 to $56 a barrel over the last six months will grudgingly attest.

To this point, the rogues gallery of TV wannabes extrapolating recent price trends to $40 a barrel has been more right than legendary oilman Harold Hamm, who infamously cashed out three years’ worth of hedges held by his Continental Resources (NYSE: CLR) this fall while a barrel of crude was still fetching more than $80.

Crude futures and options contracts expiring in March were recently pricing in an unusually wide 95% confidence interval of $40 to $80 per barrel for West Texas Intermediate, implying growing uncertainty about the price of oil three months from now.

The bearish case is disarmingly simple, and it goes as follows. For all the discounting to date, there is as yet no evidence that current prices will prove low enough to quickly bring rising supply in balance with demand that’s been growing a little slower of late.

The U.S. Energy Information Administration (EIA) estimates that commercial oil stockpiles in the developed world have risen at the fastest pace since 1997 over the last year, and should continue to increase through 2015.

With Saudis and their OPEC allies determined to defend market share and to crimp the pace of shale development in the U.S., the burden of adjustment falls almost entirely on U.S. producers. And the domestic drillers are to this point planning to spend considerably less but to produce even more oil next year, thanks to rising efficiency and declining costs.

So if $56 a barrel doesn’t cure the current oversupply, there’s every reason to expect even lower prices. If near future resembles recent past that’s the odds-on play, one not requiring much imagination.


Then again only a modicum of imagination is required to conceive a very different and much more bullish outcome. It would require neither a dramatic reversal by the Saudis nor any one of a half dozen plausible global crises capable of jacking up price. Instead, the cumulative toll of spending cuts by dozens of hard-pressed corporate drillers, combined with the realities of shale decline curves, might do the trick.

Shale oil wells decline much faster than conventional ones, and as a result more and more drilling is required to offset the expected drop-off from the wells already online. This dynamic means that a relatively modest reduction in spending on new drilling can have a disproportionate effect on net production growth.

Leading U.S. crude logistics services provider Plains All American Pipeline (NYSE: PAA) estimates that a mere 15% cut in drilling activity next year would have the effect of halving the expected U.S. output growth to 500,000 barrels per day.


And the chances of production cuts of that scope look better every time the price of oil drops. PAA CEO Greg Armstrong, who’s been talking about the possibility of dramatic oil market dislocations since June, has estimated that every drop of $10 a barrel costs U.S. shale drillers $20 billion in aggregate after-tax cash flow. That would suggest total losses from the price decline of $60 billion or so before hedges for an  industry that spent some $100 billion this year in the major basins and didn’t come close to recouping that from oil and gas sales.

The immediate future for shale drillers isn’t very bright. And precisely because of that oil prices are likely to rebound in the course of the next year.

Beyond the toll from declining shale spending by a multitude of producers large and small, there is the longer-term effect from the freeze on the development of riskier offshore projects. These lack shale’s cost advantages yet will still be needed over the long haul to make up for the exhaustion of aging conventional fields and the expected growth in the developing world’s demand.

Here’s how that demand is likely to be met in the long run according to the International Energy Agency, the research organization representing the major oil-consuming countries:


Note that the gold band at the bottom representing U.S. output is a big deal right now but a non-factor 15 years down the road. At that point the world will be relying heavily on Middle Eastern and Brazilian’s  crude, and the ability of those regions to supply it in desired volumes will be far from assured — small comfort though that may be to shale investors today.

In fact, U.S. shale’s contribution to global oversupply is likely to be far more short-lived, as the EIA recently acknowledged. Next year’s projected domestic production increase of 700,000 barrels per day would be the smallest since 2011.

Meanwhile, the cost of securing overseas production against the threat of political unrest stoked by oil producers’ economic woes should continue rising. Saudi Arabia and other oil exporters in and out of OPEC don’t have an unlimited capacity to absorb the budget deficits they’ll be running at current prices.

As for global demand, it could easily surprise to the upside. The slowdown in Chinese consumption growth slowed to 2% this year from an average of 6.5% over the last decade would need to reverse only a little to make that happen. The U.S., still the world’s largest economy and one that influences many others, has just reported 5% annualized GDP growth. Cheap gasoline appears to be stimulating demand, and the U.S. still consumes an order of magnitude more fuel per capita than China or India, a gap that’s likely to narrow by way of higher Asian imports.

Meanwhile, the EIA’s own data suggests the current supply glut is not particularly large nor especially unusual.


None of this might matter to crude futures traders as soon as March. But it shouldn’t take the market much longer to figure out that current prices are extremely likely to stall global production gains beyond next year, while stimulating fuel demand at home and abroad.