John Manfreda

Recently, Bloomberg reported that Iran’s oil minister had spoken with Mexican officials with regard to stabilizing the oil market. Iran claims that, if OPEC decides to more actively manage the oil market, that Mexico, the third largest oil producer in the western hemisphere, will cooperate with them in an attempt to stabilize the oil price.

For the general public this may seem like a new idea, but the fact of the matter is, that this wouldn’t be the first time that Mexico has co-operated with OPEC in an attempt to stabilize the oil price. The first time this happened was in 1998, when Mexico, as well as OPEC members Venezuela and Saudi Arabia, organized a coordinated production cut with 17 other countries that included Norway and Russia.

While rehashing this plan may sound great on the surface, the reality looks to be much different than it was in the late 1990’s. Since 2003, oil production from Mexico has been on a significant decline.

For the first time in 40 years, Mexico has actually become a net importer of petroleum products in its trade with the U.S. Even though Mexico is still a net exporter of oil, it is starting to import its other petroleum-based products, such as natural gas and gasoline from the U.S. So while Mexico says it is willing to co-operate with OPEC, the reality of the situation is very different now.

This is why Mexico has stated that they can’t consider any production cuts at the moment. Some analysts are even estimating that Mexico might soon go from being a net exporter of oil to becoming a net importer of oil.

Without Mexico’s co-operation, where can output cuts come from?

When it comes to production cuts other then Mexico, the first two entities that come to mind are Saudi Arabia and Russia. But Putin has already stated that he won’t be helping OPEC when it comes to production cuts, as he has just taken the title away from Saudi Arabia, to become China’s number one oil supplier. The Saudis, on the other hand, are unable to cut production as they are engaged in a battle for market share with producers from around the world, including the unconventional producers of North America, and as mentioned above, with Russia as well, among others. This is why the Saudi Arabia is unlikely to reduce its oil output anytime soon, despite the high cash burn rate its treasury is currently facing.

Now with Mexico, Russia, and Saudi Arabia out of the picture, the question remains: who is going to decrease their oil production? In my opinion, there is only one entity that comes to mind, and that entity is the U.S. shale producers.

Now the shale producers won’t willingly reduce output, as shale production is made up of many different companies, and not a national company like most global oil producers; but due to the economics of the current oil price environment, many shale oil producers will face bankruptcy next year, and as a result, will go out of business.

The reason being is that in 2016, most oil hedges will expire. These hedges have allowed shale oil companies to stay afloat and achieve cash flow neutrality, despite the decline in oil prices. These hedges have also helped shale oil companies gain access to credit, so they can raise the capital needed to put their wells into production. When these hedges expire, companies will not generate the cash flow needed to meet their covenants, which will in turn bankrupt them, and production from U.S. shale oil wells, will start declining rapidly. This will also dry up the credit markets and prevent any type of quick rebound in shale oil production.

This is why the IEA even estimates that U.S. oil output will start collapsing next year.

By John Manfreda for Oilprice.com