Oil can sink lower than we think

Everyone is wondering how low the price of oil can go. It’s well below the profitable level in the US, but the pumps keep pumping. In this earlier post I showed that oil companies will continue to pump at a loss as long as the revenue covers variable costs because the costs of shutting down an oil well can be very high.

But how long will they continue to operate with prices around variable costs? One analyst says they will do so until the cash runs out:

One in 5 energy companies could be out of cash in less than six months, while 1 in 3 will hit that threshold in less than a year...

Dozens of small energy companies had already filed for bankruptcy by December, owing a collective $13 billion, according to law firm Haynes and Boone. Many more could join them in the next year, and some may be scooped up by opportunistic buyers. Experts say that as many as a third of American oil and gas companies and half of U.S. shale drillers could disappear into insolvency before oil prices recover...

Looking at the smaller half of companies traded on the NYSE and Nasdaq, more than half of those companies are burning cash fast enough to be out within six months (based on their cash flow in the last two reported quarters).

Oil producers use their cash to pay the variable costs and store the excess production they can’t sell. But they’re burning through cash rapidly. When the cash box is empty, few banks will make even short term loans to those companies in the worst financial condition to keep operating.

Fritz Machlup, one of the great Austrian economists, wrote about the importance of cash flows to the business cycle. He contributed to the Austrian business-cycle theory the principle that the rebound in business from the recession begins when businesses are flush with cash and loan that cash to the more brave businesses who want to borrow and expand.

It takes some time before the economic system gets the crisis and depression "out of its limbs." It is only after a certain lapse of time that the crippling feeling of uncertainty begins to wear off, and the risk estimates by potential lenders and borrowers gradually fall. When finally confidence has returned and the spirit of enterprise has reawakened, the firms which have accumulated large balances of cash during the period of liquidation find that these liquid funds are superfluous and that there are outlets for them. ..As soon as the "surplus cash reserves" have found "productive employment" the economic system is moving into the upward phase of the cycle.[1]

And cash determines the turning point at the top of the cycle as well:

The further the use of money market credit has progressed or the more intensively credit is being used in production, the heavier and more urgent will be the demand for credit on the money market at the critical payments dates. Thus Halm is right in saying that "The real shortage of capital at the top of the boom is a shortage of short term capital disposition."[2]

The next step will be large numbers of bankruptcies. Only then will production decline enough to build a solid foundation for prices to begin rising again.

By the way, this same analysis applies to mining with the major difference that iron, copper, gold and silver ore are much cheaper to store. Mining companies will continue to dig until their cash runs out.

The above refers only to private companies, but governments own most of the oil in the world
and depend heavily on tax revenue from oil sales to fund bloated bureaucracies. Few can afford to cut
production, so the worldwide oil flood will probably continue for quite a while.

[1] Fritz Machlup, The Stock Market, Credit and Capital Formation, (London: William Hodge and Company, 1940), 246-247.

[2] Machlup, Stock Market, 244.