This week major oil companies such as Exxon, Conoco Phillips, Chevron and BP announced losses, cut dividends, slashed capital expenditures and eliminated share repurchases. A substantial number of energy companies are in discussions to restructure their loans and bond issues. Some of these companies are in bankruptcy and are likely to face more insolvency.

The High Yield market is declining as the magnitude of the capital loss is amplified by the decline in energy prices. Most of the energy debt exposure is held by High Yield mutual funds and Hedge funds, not the banks. This is an important distinction. The High Yield market is designed to withstand a certain level of defaults and restructurings. Potential losses, while painful, should not cause the systemic collapse of the banking system and its ability to extend credit to the U.S economy.

With anxiety in the market, now is a better time than ever to look at what we know about supply and demand and the Crude Oil market. The laws of Supply and Demand have always dictated the price of goods but sometimes other factors can swing prices in the short term. Recently, crude oil has been swinging 5-8% per day on rumors and algorithmic trading.

Supply was estimated to exceed daily demand in the world by 1-2 million barrels per day over the past year. Overseas, Saudi Arabia has been unwilling to cut back on its production and give up their market share if other OPEC and non OPEC producers do not cut their production as well. Iran is in the process of reentering the World petroleum markets and will likely cut their price to gain a piece of the market.

In the United States, the number of drilling rigs has plummeted but production has only just begun to tail off. That is because the development of new technology in the Oil Service industry has vastly increased productivity. As you can see in the chart below, production continued to increase after the number of operating rigs plummeted, reflecting higher productivity. New technology, such as hydraulic fracturing has completely changed the world energy markets.

In the oil industry, new wells produce at high rates and then production begins to decline, usually sharply in the first year and slowly thereafter. Oil and gas fields require continuous investment in production stimulation to keep well production from declining. At $100 oil, spending was easy to justify. At current energy prices, less is being spent on field maintenance. Decline rate could accelerate as fields age and new wells are not brought online. With worldwide energy production of 90 million barrels per day, it will only take a slight increase in decline rates to overcome the 1-2 million barrel per day surpluses.

It may take more than a supply/demand balance to positively impact prices. Crude oil and refined products are filling up storage. The futures markets are in Contango, which means the spot price of crude oil is substantially below future prices, reflecting currently well supplied markets. This week, U.S. Petroleum Inventories exceeded 500 million barrels, the highest in 80 years. Even if the rumors are true and OPEC and non OPEC producers are able to come to a supply cut agreement, there is plenty of inventory on land and at sea.

The high levels of inventory mean it may take several more quarters of much lower capital expenditures and production declines to balance out the worldwide energy markets.

Joseph F. Hickey is Director of Equity Strategy at Cleary Gull

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