Oil @ USD25-USD40 For The Next 2 Years

The Premise - Oil like other commodity has been in a sharp down cycle, as in any commodity cycles, they are bound to turn up. Usually the the U curve of these commodity plays lasts anywhere between 2-5 years. If we look at the basic commodities, they have been on a downcycle since the subprime crisis in 2008 - since there had been easy money and over investment in particular by China. However oil held its own and in fact went to as above USD110 in 2013. Since then it has fallen to USD30 as of early February 2016.

Picking Bottoms - It is hazardous to say the least but at USD30 we are probably in the last quartile of correction. The justification being the cost of production. The cost of production below was in 2014, as of today we can impute a higher cost of between 10-20% based on weaker economies of scale and USD strength. 

Cost of Production By Country - We can surmise that Saudi Arabia wanted to crush Iran and the latter’s cost of oil extraction is between USD15-16, which would indicate some downside could be in store. Iran has received a lifting of sanctions which would see their current export of 500,000bpd to escalate to 2 million by April/May 2016. At below USD30, the number of players still operating profitably will just be among the Middle Eastern producers. 

If you were to look at The following two charts above, it will tell you that the surge in oil prices above USD110 over the last 4 years have largely been by increased US production. By and large, we can argue that Saudi’s move to weaken oil prices was two pronged: to kill off the shale producers and weaken Iran’s power - the former has been well achieved and the latter has also shown to be effective. 

The Rebound Limit - Yes, we are probably in the last quartile of the trough but one thing is clear there will be a limit in a rebound as Saudi will not want the shale producers to restart their production easily again. Hence if you look at cost of production chart, that objective can be attained by keeping the rebound range to USD45-60 over a sustained period.

Since the fateful November 2014 OPEC decision to maintain output, defend their market share, and kill off high-cost producers around the world, particularly North American shale and oil sands - we are left with Saudis crushing Iran being the last objective. However since the lifting of sanctions for Iran the Saudis would know that it is almost fruitless to continue doing so. As the cost of shale is at least USD60-70 on average, most have closed shop and declared bankruptcy.

Consensus Estimates - If you were to look at the average consensus estimates by EIU, IMF and other international agencies, its between USD60-65 over the long run. They could all be wrong, and even if you were to discount their estimates, it should still be in the range of USD50. That should be where we should be looking at over the next 2-4 years.

The Breakeven Factor - On the first page we have looked at the extraction cost of oil per country. But that is not the key factor, every country have differing needs and diversification of industries. The more reliant you are on oil, the more it will be impacting the country’s budget. Hence even when Iran have their sanctions lifted, and technically it can ramp up to 2mn-3mn barrels a day, plus their extraction cost is below USD20 per barrel - it does not mean they are laughing. Iran needs oil to be at USD140 to balance the budget. If you think (like me) that part of the reason the Saudis are letting oil price crash is to hurt Iran, then the Saudis are in no mood (yet) to let oil price rise at a time when sanctions has been lifted. 

Hence almost all the Middle Eastern countries have very high breakeven levels, but some have ample reserves to see this through for sometime still. Namely Saudi Arabia, Qatar, Kuwait and UAE. The rest are finding it very tough.

Saudi Arabia's net foreign assets have been dropping at almost $8 billion per month meaning the company has only 5-6 years of reserves left. While the company's Saudi Aramco IPO might raise much needed cash, it is a show of desperation that might not be best for the country.

More so, compared to other countries, Saudi Arabia has the best situation. Other countries like Libya, Venezuela, Iran, and Nigeria are in much more need of cash. Non OPEC producers such as Russia might be looking to get in the action and make a deal to cut production. A relatively minor production cut of 1-2 million barrels per day could easily push oil prices back up to $60 or more barrels per day.

Saudi Arabia might call it a day since the sanctions has been lifted for Iran as it probably not much use to keep oil prices below USD30 for a persistently long time. Saudis’ strategy now lies in achieving its other objective, to dismantle the US/Canada shale oil production infra. But you can see that US oil production is still high and is taking its time to reduce, hence I think the Saudis will wait a few more months to see further declines in US production before reversing oil price trend.

The Big Picture - Why are we in the present predicament? Global capital spend for big miners was just US$4bn in 1991, that went to US$14bn in 2001. China was a key factor after it entered WTO in 2001. Global mining capex went from US$14bn a year in 2001 to US$125bn a year in 2012. The over investment largely by China has to work itself off. In a slowing global economy and a substantive slowing in China growth can explain a large part of the commodities down cycle over the last 5 years.

The Decisive Factor - Besides the Iranian factor, the Saudis likely will not feel comfortable about the chances of a US output boost until production in the United States falls to 8.5 million barrels per day. But it could be next year before US output hits that level. US oil production has fallen to about 9.2 million barrels per day, according to preliminary weekly EIA data. Until there is shock and awe in terms of bankruptcies and super-low prices, there is going to be unrelenting selling pressure in this market.