On June 2nd, OPEC meets once again. Some naive speculators believe this will be the time that OPEC supports the price of oil. They will be very disappointed once again. What will be clear by the end of the meeting for the world though is that we are seeing an extinction level event for new deep water and oil sands development.

Iranian Oil Prodcution
Iranian Oil Production

We have been watching and listening to the turmoil in the oil markets for nearly two years now. When I first warned of a crash in oil prices in June of 2014, even I didn't realize it would be this severe or prolonged. I had expected 2016 to be the year that oil prices rebounded significantly and could be expected to be over $80 per barrel. That won't happen until at least 2017 and maybe 2018.

What Crown Prince bin Salman of Saudi Arabia has hinted at recently is that his nation has no intention of leaving cheap oil in the ground in order to help more expensive oil. This is not just about preserving market share, this is about taking more market share. The Prince has said that Saudi Arabia could raise their production to 11.5mbd from 10.3 within weeks. He has further said it wouldn't take much longer to raise Saudi production well past 12mbd. I expect both things to happen imminently. 

In Iran, Rokneddin Javadi of National Iranian Oil Company recently said that , "the government has no plans for the time being to freeze or interrupt its increase in oil output and exports based on plans that are being carried out... In the current context, the oil ministry and the government have issued no policy or program to halt the increase in production and exports and so, the country’s plans to increase crude output continues.” It is clear that Iran will hold to their word and increase production to at least 4mbd soon.

Despite the additional production from Saudi Arabia and Iran, oil prices have firmed up on speculation that there might be cooperation to buoy oil prices and due to several disruptions in production around the world. To be sure, sabotage in Nigeria, fire in Canada and war in Libya have had significant impact on oil supply in the very short-term, however, the reality is that those disruptions are temporary.

Oil inventory is still at multi-year highs, so temporary disruptions to oil supply have limited lasting impact. In addition, American oil companies are now hedging production and starting to tap DUC wells in order to add cash flow. There is little in the fundamentals given flattish demand to suggest the surge in oil prices continues this year. Investors should expect oil prices to be range bound for an extended period of time, I believe until spring of 2017.

With oil prices likely to be stuck in a trading range due to additional supply in the short-term and no sustained demand growth, that is a further hit to the deep water drilling and oil sands complexes. According to Rystad Energy there have been 35 cancelled drilling projects the past two years and demand growth in 2017 is set to be tepid. If low prices persist as I believe, there would likely be further contraction of deep water drilling. This is another blow to service companies that recently took on big debt to buy new rig fleets that are suffering low pricing and utilization. 

In Canada, as I mentioned last week, the Canadian Association of Petroleum Producers have outlined that projected increases in oil sands production are falling off of a cliff. It is openly being discussed in Canada that there might never be another new oil sands development. While I think that is an exaggeration, we might really only see 2 or 3 more developments in the next decade, with those being the last ones ever. 

Coupled with improvements in shale development costs, what Saudi Arabia and Iran are doing amounts to an extinction level event for many oil drilling companies and some E&Ps that are heavily dependent on deep water oil fields. Look at this chart from EOG Resources (EOG):

Oil Production Costs
Breakeven Oil Prices

As I suggested would happen, shale has opened a clear advantage over deep water and oil sands on a cost basis. Remember, shale can be drilled in small increments relatively quickly. Deep water oil and oil sands are mega-projects that require lead time, huge capital commitments and many years to payback investors. In the next decade, we should fully expect Saudi Arabian, Iranian and other cheaper oils to take market share from deep water and oil sands. 

We should also expect shale oil to become the swing producer. Those companies without deep water exposure, that have the most efficient plays in the Permian Basin, such as Devon Energy (DVN) and Eagle Ford, such as Chesapeake Energy (CHK) and Conoco Phillips (COP) could do very well going forward. Note that Devon and Conoco both cancelled deep water exploration moving forward.