We recently offered up some thoughts on investment prospects for Brazilian equities. Sadly, we came out largely negative on that perpetually promising market but we did pause to consider the consequences of the country being bailed out, again, by a significant rally in commodity prices. President Lula accumulated much of the credit for Brazil’s economic boom in the early ‘00’s – and certainly, defying predictions, he refrained from defaulting on Brazil’s foreign debt in 2003 which was a good move. However, it was the massive shift in the terms of trade caused by the price of iron ore, oil and steel rising seven-fold (roughly) which, in our humble opinion, really drove growth from 2002 to 2007.

So, during our pause, we pondered the possibility of our bearish conclusions on Brazil being upended (seemingly the verb du jour) by what would be considered a largely unanticipated extended rally in commodity prices. Specifically, we started to ponder the outlook for that granddaddy of all commodity prices, the one most other commodity prices follow; oil.

Oil is ubiquitous, plentiful, cheap (at least when left untaxed) and has positioned itself persuasively as the fuel of choice for transportation globally. Lost in the controversy over its role in warming the planet is the fact that we (the generations who have lived from the beginning of the 20^th century to today) have benefited enormously from oil’s union with machinery, especially the internal combustion and jet engines, and the staggering increases in productivity –and standards of living – that this union has produced.

And although many feel queasy about burning it, there is still an awful lot of oil in the ground. Including recoverable and unconventional reserves, we have just over 4trn barrels of oil in the ground, which should last us at least another 120 years, assuming current rates of consumption.

As a commodity with high capital costs (at least for conventional oil production) and low production costs, we should expect the price of oil to be volatile and it has not disappointed us. It has made the round trip from below $20/bbl to $120/ bbl twice in the last 50 years. Almost.

The latest round trip began in 2001 with the oil price at $19.84 at year end. Over the subsequent nine years, China, Asia and other developing countries provided the growth in demand while the old Soviet Bloc provided the growth in supply, ably assisted by OPEC. While the overall growth in demand was not that high, 1.5% p.a. thanks to declining OECD demand, OPEC kept supplies tight, especially during the second half of the period. As a result, from 2007 through 2011 the market was in deficit and the oil price soared in response, peaking at just over $100 in 2011.

Then, in 2011, the market was hit with an exogenous factor – new technology. Suddenly, oil could be produced from rocks. Of course, only the US had the legal, technological, financial and regulatory frameworks in place to enable oil producers to take advantage of this new technology. So the US ran away with the industry.

In less than 10 years, the US shale oil industry went from zero to $70bn in revenue and $600bn in invested capital. After years of gentle decline, oil production in North America leapt from 14mb/d in 2010 to 19mb/d in 2014. Coincident with this increase in supply, growth in production from the Soviet Bloc subsided. But it did not matter. OPEC, loathe to give up too much market share, also increased supply so that by 2014, the oil market had added 8.1mb/d in supply vs just 5.3mb/d in demand and was solidly in a position of excess supply.

It took the oil price until the 4^th quarter of 2014 to realize its predicament. Making up for lost time, it halved in the last three months of the year. During 2015, the price has been generally weak, breaching the $40 level in August.

Demand for oil is generally thought to be fairly inelastic. Accepting for the moment that this is so, let us turn our attention to supply. How is supply going to respond to $40 oil?

The first participant to consider is OPEC, or more precisely, Saudi Arabia. Saudi Arabia wants to break US shale oil. It wants to inflict the sort of damage on shale that causes investors to give up any expectation of a predictable return on investment. It wants to keep prices low enough for long enough to staunch the flow of capital to the industry and thus eliminate the most effective competitor to emerge in OPEC’s lifetime. This tactic is not without its costs. Saudi Arabia will run a budget deficit of close to 20% of GDP this year and is rumoured to be considering devaluation.

The country, however, does have a long-term time horizon, $672bn in foreign exchange reserves and is unconstrained by the exigencies of shareholders or voters. In conclusion, it seems prudent to assume it will carry on pumping regardless of price, at least in the medium term, to “maintain market share”.

So what of US shale oil producers themselves? Low oil prices were supposed to annihilate these upstart, high cost participants. Unfortunately for the Saudis, six months after the oil price slump, only five out of hundreds of companies in the US have gone out of business. And while US production has stopped growing, plateauing at between 9.2 and 9.6mb/d for the first half of the year, it has not collapsed in the face of lower profitability.

Industry pundits have hastened to explain the industry’s surprising resilience. The most important, optimists say, is that shale oil is not high cost any more.

Lower oil prices have merely accelerated the industry’s propensity to consolidate, cut costs and use better technology – micro-seismic study, well production history and big data analytics – to drive productivity. Last year, break even in the Bakken region was thought to be $60/bbl. Today, some counties report break even of $20/bbl. Six to eight years ago, the estimated recovery factor in Bakken shale was 3-5%. Today it is 15-18%. Some believe that shale 2.0 promises ultimately to yield break even costs of $5-20/bbl – the same range as Saudi Arabia’s vaunted low cost fields.

Second, to help lower the cost curve even further, suppliers helpfully dropped their prices by 20%. Third, $40 oil was not even being felt in the first half of 2015 because hedges were still delivering effective high prices.

And lastly, delighted with the industry’s audacious response to low oil prices – self-imposed austerity coupled with high production – Wall St continued to supply capital, a whopping $44bn in equity and debt financing in the first half of 2015.

The Saudis are not amused. The Saudi Central Bank, voicing the country’s displeasure, admitted that “it is becoming apparent that the non-OPEC producers are not as responsive to low oil prices as had been thought, at least in the short run”.

And there’s the rub. In the short run. By the beginning of next year, a lot of those helpful hedges will have expired and income statements will be exposed to the harsh reality of market prices. And while oil production has held up, the drilling rig count is down big time, from 1600 in October of last year to 644 in mid-September. New wells, for future production, are not being drilled.

Moreover, as a new, technology-intensive industry, shale oil has been gobbling up external capital to finance its rapid growth. Between 2009 and 2014, an index of Bakken oil plays reported cash-flow from operations increasing from $875m to $7bn. Nice, but not enough to cover capital spending that grew from $1.3bn to $11.1bn over the same period.

And now, that same index of Bakken oil plays just lost $449m in Q2 2015 compared with reporting $288m in net profit in Q2 2014 and its debt to capital ratio stepped up from 56% to 63%. While these Bakken producers may not be as high cost as they were, they are apparently not as low cost (yet) as the optimists had hoped.

How long will Wall St be willing to wait for, and fund, the miracles in productivity required to turn losses into profits at current oil prices?

Wall St is not a very patient place and it is almost impossible to believe that funding will not feel the pinch after another quarter or two of losses. In our humble opinion, it is a mistake to assume that just because production has not been cut yet that production will never be cut.

In the old oil market, there was only one producer (apart from a flurry of activity for a few years from the old Soviet Bloc) who could increase supply in the long term – OPEC. In the new oil market there are two producers – OPEC and anyone who can frack.

This is the new paradigm in which the oil price will have to find its new equilibrium – determined by shale oil’s marginal cost of production (which is downward-sloping over time). Not low enough to choke off US production growth completely, but not high enough to justify the 9.2% p.a. rate of production growth sustained between 2011 and 2014 (which added 1.9mb/d to supply last year in a world that only wanted an extra 1.2md/d).

Ah, but what about OPEC? Yes, OPEC will have to decide how best to approach the change in its circumstances.

In one possible scenario, a self-delusional Saudi Arabia continues to try to kill off US shale once and for all by keeping prices ultra low. But, really, the Saudis already realize this is going to cost way more and take way longer that they originally anticipated. Also, they have no guarantee that there would not be a resurgence in activity (capitalism being what it is) after months, even years of $20 oil, if the market even sensed a return to the status quo ante.

This scenario, in our minds, is unlikely and, should it nevertheless come to pass, unsustainable. The Saudis are sane. This means that we eventually arrive at a second scenario where Saudi Arabia admits it cannot win a war against technological advancement, accepts marginal cost pricing, and the oil price settles somewhere between $35 and $55.

Which leaves Brazil, circling back to the original trigger for these musings, without its commodity bull market bailout – at least from oil.