Phil Flynn: Saudi Oil Price War A Bloodbath For US Producers

January 16, 2015

Energy analyst discusses the oil market.

This is part 1 of our interview with Phil Flynn. Click here for part 2.

Phil Flynn is senior energy analyst and a futures account executive at Chicago-based The Price Futures Group. He is one of the world's leading energy market analysts and a daily contributor to Fox Business Network, where he provides market updates and analysis. HAI Managing Editor Sumit Roy recently caught up with Flynn to discuss the latest developments in the oil market.

HardAssetsInvestor: The last time we talked was back in October when WTI was more than $80/barrel; earlier this week it hit $44. You were spot on with your call about how OPEC was not going to cut production and how prices were going to continue lower. But were even you surprised by the speed and magnitude of the recent decline?

Phil Flynn: I definitely was; I think everyone was. I expected it to fall, but the dramatic fall and the speed caught a lot of people by surprise. It was a combination of the OPEC price war, as well as the timing of the price war, which coincided with rising concerns about global economic growth. It was the perfect combination, a one-two punch that really just knocked this market out.

A lot of people in the market were surprised that OPEC decided to declare war and a lot of people were in denial. They said, "there's no way OPEC's going to do a price war, that's not really going to happen. They're going to cut production, come on. They'd be crazy not to do it." Well, apparently they're crazy like a fox, because they didn't cut. And they did it in such a way to really hurt the U.S. energy producer.

HardAssetsInvestor: Do you think OPEC made the right choice by not cutting production back in November?

Flynn: It depends on your point of view. The reason the Saudis made the decision is they realized that if they cut production, the US energy producers are just going to fill that void. The Saudis thought "the more we cut, the more they're going to produce, so we've got to send them a message."

Now, when the market comes down for normal supply and demand reasons, people adjust. The U.S. energy producers would have been hurt. There would have been winners and there would have been losers, but it wouldn't have been a blood bath. The Saudi price war is a blood bath and they're doing it because, for them, it's a fight of survival.

Some people are saying, well, that's just capitalism. But capitalism isn't supposed to be countries conspiring together to try to drive people out of business by selling their products at a loss, which is basically what OPEC is doing. None of them are making a profit; based on their production costs maybe they are, but not based on their government budgets. They're all losing on this.

But they're willing to lose in the short term to try to regain their importance for the long term. OPEC is not just up against the U.S. energy producers. We're talking about alternative fuels; we're talking about Tesla; we're talking about electric cars; we're talking about all these technologies. And while they might not be able to stop those technologies, they'd better slow them down. That's their attitude.

As a free market guy, I don't like it. I like the market and supply and demand to pick the winners and losers. But we know in the real world, when you've got cartels banding together, it's a little harder to do that.

HardAssetsInvestor: You mentioned that for the U.S. oil producers, it's a blood bath out there. How are they responding to these lower prices? Are we going to see the end of the oil boom in this country?

Flynn: No, we're not going to see the end of the oil boom, but it is going to start to slow down. We've heard from the Department of Energy that production is still going to rise this year, even though we're seeing some of the most significant cutbacks in oil exploration than we've seen in 20 years. We know that there's going to be capital expenditure cuts across the globe. We know that there's going to be jobs that are going to be lost, and jobs that would have been created that are not going to be created because of this oil bust.

HardAssetsInvestor: How are these oil companies still growing production, even though they're cutting back their capital expenditures?

Flynn: A lot of projects were put in place before the oil crash and companies have also hedged their production. As for the wells that are already in production, they're bought and they're paid for so they're going to be able to ride this out. The problem is trying to get the capital for new projects, which is going to be harder to come by because people are afraid to invest money because the market's been in a free fall.

All the projects that are already in place means that we're probably going to see production rise, but by midyear, it's going to slow down. We'll still end the year higher than we did the year before, but with a bullet going into next year.

HardAssetsInvestor: You're saying that we'll probably see declines in 2016?

Flynn: Correct.

HardAssetsInvestor: How about the other side of the equation. We talked a lot about supply, but are we seeing any response on the demand side?

Flynn: We better hope so, because if we don't, then the economy's in really tough shape. Even though demand for gasoline in the U.S. has been strong, you would have thought with the drop in gasoline prices, it would have been a lot stronger. If you look at some of the economic data for oil around the globe, whether you look at China or whether you look at Europe, it's not really blockbuster data. Their economies are slow and they're under the threat of deflation. We're not seeing the low prices kick-starting those economies.

Could we see that months down the road? Maybe we could. Every central banker in the world is praying that it's going to happen. But we haven't seen signs that it's happened yet. And we'd better start seeing signs pretty soon, because if we don't, then these low oil prices are going to look like deflation and it could reinforce the situation where we would not only tighten up credit for the energy industry, but other industries as well. This does have the possibility to spread to the larger economy, so we really need to see this drop in price stimulate demand.

HardAssetsInvestor: Do you think this week's $44 bottom in prices will hold?

Flynn: When we talk about bottoms, we can talk a bottom for five minutes or 10 minutes or a month, or a historic bottom. The way the market has bounced back, this could be a formidable support area; it could be a number that could hold up over time.

Now, whether it's going to be a number that's going to hold up for a month or the rest of the year really is going to depend on the outside markets at this point. Oil has showed signs that it's had enough, but that doesn't mean we're going to go $20 higher. It does mean that we probably have found an area where the market is going to pause and consolidate. That means that the market will try get a handle on the new fundamentals—where are we at, where are we going with supply and demand. And then it determine whether that low is going to hold or not.

The market may be waiting around to see if we're going to see some demand response. If we don't see demand increase in the coming weeks, then the $44-a-barrel area will just be a stopping point, and you'll probably go down even lower.

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