When will Oil bottom? I guess when economic rational decisions lead to economic rational outcomes!

So far, Saudi Arabia, Iran, and Iraq seem to be the only producers making economic rational decisions: they continue to raise production because price remains well over their marginal cost of production. But even within this rationality, there is irrationality: by all means don’t cut production, but why raise production, when it is not required – all it is doing is going into inventory and making a bad situation worse. For heaven’s sake, they could sell less Oil for more money simply by matching production with consumption. To be fair, they had act to force an answer to the question of who could produce at what price.

But then why should they? After all we have Angola, Nigeria, Equatorial Guinea, Brazil, and Russia amongst others who could cut. Prices are almost certainly well below their marginal cost of production from deep-water and harsh environment wells. They don’t cut, because nations don’t always respond to the profit motive until they have no choice. 

In the United States too, there is much production well underwater. But we are only just beginning to see cuts work their way through the system.In the early months of the Oil price crisis, there would have been significant sunk costs, and so continuing to produce below marginal costs might have made sense –  because revenue would have been higher than cash costs. And cuts might have been deferred, because contango meant producers could continue to produce and store profitably, even if spot prices kept them underwater.

I often watch for backwardation because once we have it, there is no incentive to store, and so the futures market is dead for producers, with spot being forced into a decline as a result. This time I don’t think backwardation will be necessary. We still have contango -we have December 2016 trading at $37.50, December 2017 at $41.13, and December 2018 at $43.69. The contango is good news for financial investors. But for producers, the forward prices are well below marginal cost of production. And absent an incentive to produce, production will be cut.