How A Bathtub Can Explain The Current Oil Market

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Can a bathtub explain the oil markets today? Some analysts not named Bill Gross believe so.

Trying to predict oil prices has become an impossible task over the past 12 months. After rebounding from the lows printed during mid-2016 the beginning of this year, the price of Brent has recently slid back to the mid-$40s amid concerns that OPEC’s actions to try and cap the oil glut are having little impact. What’s more, earlier this week in Russia announced that it would oppose any attempts to deepen oil production cuts already in effect.

Analysts at Berstein also believe that ‘earth-shattering’ shale supply will counter the existing OPEC production cuts. The analysts estimate that non-OPEC supply will increase by 0.6 million barrels per day in 2017 and 1Mbpd during 2018, justifying a $50 per barrel price in 2017 and 2018 down from original forecasts of $60 and $70.

No matter where you look on Wall Street, all analysts are predicting similar moves. according to the latest forecast from Deloitte, while OPEC cuts removed 1.8Mbpd from oil Markets today, which has helped keep WTI prices at or around $50/bbl, stability will not last for much longer. The report notes:

“What we’re finding is the producers are able to bring and drill new wells very efficiently, so I think what we’re going to see is companies being very efficient with where they spend their capital, and also at the same point in time, being very careful they’re not over-extending themselves into big debt situations.”

Deloitte estimates the WTI price will remain rangebound between $45 and $60 for the foreseeable future. Meanwhile, Bank of America has warned on the effectiveness of OPEC’s cuts. According to research from the bank, OPEC exported 25.92 million bpd in June, 450,000 bpd above May and 1.9 million bpd more than a year earlier. Based on this rising production, BoA estimates Brent will average $50/bbl this year and $52/bbl in 2018.

These forecasts may all be different but they all have one thing in common; they indicate oil prices will remain low for the foreseeable future. Bernstein analyst Colin Davies likens the current oil environment to a bathtub, specifically, the rather complex process of deciding on the most efficient to fill a bath tub and regulate temperature at the same time.

How A Bathtub Can Explain Oil Markets Today

Davis writes that the bathtub problem is a “classic problem in process control” with sensors, in this case, your fingers, to check the water temperature, a transmitter, in this case, your nerves, communicating information. A controller, in this case your brain, interpreting the information and an actuator, in this case, your hands, adjusting the faucet to regulate the temperature. This system is a closed loop feedback control where the “action on the process is informed by feedback from the results of prior actions.”

So how does this analogy fit  Oil Markets Today? Well, the oil industry operates on the same closed-loop feedback system. As Davis explains:

“At the simplest level, oil companies “sense” the oil price outlook and “transmit” that information into cash flow planning. The (not so) intelligent “controller” then sets spending levels (usually too high) and the “actuation” is the addition or subtraction of rig count and oil field activity. Rig count, in turn, defines production growth which for a given level of demand “feeds back” into oil prices. Finally, there’s the added complication of accumulation – water level in the bathtub…..or oil inventories.”

In this scenario, one tap will be shale oil and the other one can be deepwater production. The problem is, just as with filling a bathtub, the result will never be exactly correct, you will always end up swinging one side either way and with the bath tub (oil inventories) already quite full, room for maneuver is limited.

An interesting concept and one that does go some way to explaining why prices are destined to remain depressed.

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