Oil Shock Part 1 – “The Great Sweating”

The price of crude oil, adjusted for inflation is at 1979 levels, having fallen by over 50 percent since June 2014. This is not the first oil price shock but part of the periodic conflicts in the oil market that John D. Rockefeller a century ago called the “great sweating”.

In 1973, the oil price quadrupled from US$3 to US$12 per barrel. In 1979, the oil price rose from US$15.85 to $39.50 per barrel, which remained the highest real price until March 2008. In the 1980s, the oil price fell from around US$35-40 per barrel to below US$10, a fall of around 70 percent. In 1990, the oil rose from US$17 to $36 per barrel then declined to a low of US$20 per barrel in 2001, a fall of around 60 percent. Between 2003 and 2008, the oil price increased from around US$25 to US$147 per barrel. Following the global financial crisis of 2008, prices fell to around US$40 per barrel, a fall of around 70 percent.

Murky…

The oil price fall reflects a cocktail of market and strategic factors.

Weak demand contributes perhaps 30-40 percent of the fall. In 2014, oil demand grew by around 500,000 barrels per day, below the 1.3 million barrels growth projected earlier, reflecting weak economic activity in Europe, Japan and emerging markets, especially China.

Increased supply contributes 60-70 percent of the decline. In a pattern reminiscent of earlier price cycles, several years of high prices and strong demand has encouraged new sources of oil supply to be brought on stream, causing the price to adjust. The US alone has added 3 million barrels a day of new supply just in the last three years alone, the equivalent of adding a new Kuwait or UAE to the world oil market.

Additional production comes from traditional sources, such as Libya, Iran and Russia. It also come non-traditional sources, US shale and Canadian tar sands. Black market oil supplies from Islamic State controlled Iraqi oil may be a minor factor.

Oily Politics…

The increased supply has been exacerbated by the refusal of OPEC, led by Saudi Arabia, to cut output for strategic and geo-political reasons.

Historically, Saudi Arabia, a large producer and possessor of substantial low cost reserves, has acted as the ‘swing producer’ in the oil market. It adjusted its production to bring supply and demand into equilibrium. This role is a key source of Saudi power and influence in the energy market and geopolitics. This power has waned in recent decades.

OPEC, the industry cartel through which Saudi Arabia traditionally exerts its influence, is in decline. OPEC’s market share has fallen from over 50 percent in 1974 to currently around 40 percent. Non-OPEC production is now around 55-57 million barrels per day, around 60 percent of the oil market.

OPEC faces increasing competition from shale liquids, deep water and arctic oil, liquid natural gas as well as renewable energy sources, much of it made possible by technological advances and high oil prices. The rapid development of the shale industry in the US, with the addition of perhaps 20,000 new wells since 2010, has boosted US oil production by one third to nearly 9 million barrels a day just 1 million short of Saudi Arabia’s output.

Compounding OPEC’s problems are efforts to reduce oil intensity and decrease the role of oil as a transport fuel. The poor financial condition of some OPEC members, which makes it hard for them to reduce production because of the need for oil revenues, exacerbates the decline of the cartel’s power and its ability to dictate prices.

From the Saudi perspective, the primary benefit of high oil prices has accrued to non-OPEC members. A cut in Saudi or OPEC production to support prices would only further benefit these oil producers. The Saudis are mindful of history. In the mid-1980s, Saudi Arabia cut its outputs by close to 75 percent to support weak prices. The Saudis suffered a loss of revenues and also market share. Other OPEC members and non-OPEC producers benefitted from higher prices. In recent years, Saudi Arabia has regained market share, benefitting from the disruption to suppliers such as Iran, Iraq and Libya. The Saudis are reluctant to cut production, preferring to maintain market share rather than prices.

The strategy is to allow prices to fall to levels below production costs of high cost producers and non-traditional oil sources.

The opaque nature of oil economics makes break even prices difficult to identify with certainty. The often low marginal production cost differs significantly from the full cost, incorporating exploration, development and fixed costs. In addition, costs of individual producers and fields are highly variable. Hedging arrangements in place often for medium to long periods also complicate analysis.

The average breakeven cost currently is probably between US$60 and US$70 per barrel.  Importantly, US shale oil may not economic below those price levels. Perhaps as much as 80 percent of shale reserves are uneconomic are prices below US$80 per barrel, at least based on current technology.

In the short run, producers may continue to produce and sell at below full costed breakeven prices. If oil prices stay low for a sustained period, then producers will be forced to cut production, with marginal or higher cost firms forced to close or declare bankruptcy. Most importantly, irrespective of production level changes, expansion and new investment will low and eventually be wound back. For example, oil price above US$100 a barrel would allow deep-water reserves, arctic oil, tar sands or shale deposits in countries like Canada, Poland, Argentina and Venezuela to be profitably developed. Lower prices will make these uneconomic. The lack of investment capital will ultimately reduce immediate supply and the potential resources for future production worldwide.

Geo-Oil…

In theory, Saudi Arabian oil and foreign policy are separate. In practice, they are related. The oil price shocks of the 1970s were, in part, a response to Western support for Israel and the Arab humiliation in the six-day war.

Low oil prices hurt Iran, Saudi Arabia’s competitor for Middle East political influence. It is revenge for Iran’s support of the Shiite factions in Iraq, allegiance with Syrian leader Bashar al-Assad and its destabilising nuclear program. Low oil prices also hurt Russia, who also supports Syria and Iran. Low prices also undermine the financial basis of Islamic State militants, whose sales of cheap smuggled oil funds their military activities.

Low oil prices can be seen through a Saudi prism as reprisals against the US. It is designed to undermine American attempts at greater energy self-sufficiency through aggressive exploitation of its shale gas and liquid resources. It is revenge for America’s strategic rebalancing away from the region to a greater Asian focus. The oil strategy is a signal from Saudi Arabia that it wields significant power and should not to be treated casually in geo-political terms.

Short or Long Lows…

The period over which the oil price remains low affects its long term impact. Some argue that the oil prices have entered a new range of US$20 to US$60 per barrel. Some are purchasing put options which pay out if the oil price falls below US$40. Others see the fall as temporary, seizing the opportunity to purchase assets cheaply.

Oil demand is likely to remain lacklustre with economic growth slow in most of the developed world and emerging markets. Conservation measures and environmental pressures are reducing long-term oil demand. Oversupply is also likely to persist, at least in the near term.

Saudi Arabia and OPEC are unlikely to adjust production significantly. Oil minister Ali al-Naimi has pointedly stated that Saudi Arabia will not cut production even if oil prices fall to US$20 per barrel. It is a historical shift, emphasising market share rather than high prices, by controlling supply. Underlying the strategy is the focus on allowing low cost, efficient oil producers to increase their market power.

Saudi Arabia is well placed to implement this long term strategy. It is the world’s largest crude oil exporter. It has 25 per cent of the world’s oil reserves.  It has invested to maintain 2 million barrels per day spare capacity (over 80 per cent of global spare capacity). It also has about US$900bn in foreign assets, giving it the capacity to survive significant fall in revenues from lower oil prices for an extended period.

One constraint to the strategy is political. Given lower prices damage US shale gas and oil producers, the complex politics of the Saudi-US relationship will dictate that objective is to manage the market share of shale oil rather than eliminate it completely.

Other supplies are also unlikely to fall in the near term. Countries with a high dependence on oil related revenues will be forced to increase production to maintain cash flow. The US shale oil industry has more capacity coming on stream and is likely to increase production despite economic pressures, focusing on cash flow rather than profitability. High leverage and high debt servicing commitments will drive this behaviour.

The basic characteristics of the oil industry and its price cycles compound the high supply levels. Energy projects take years to bring to production. They have long working lives, up to 50 or more years. Consequently, the relevant price volatility is that around long term trends. The major focus is on structural forces such as long term supply and demand, technological developments which makes more resources accessible at lower cost and regulatory actions, such as subsidised national energy self-sufficiency and emission costs.

In the present low price environment, these factors will drive postponement of investment in more expensive or marginal projects and an acceleration of cost cutting and efficiency enhancement initiatives. This makes lower prices tolerable. Lower production costs allow further price declines. The ability to absorb low oil prices is not infinite, but based on past cycles the limits are large and have not yet been reached.

But price forecasts could easily be wrong. The structure of the oil market entails fine margins between demand and supply. The current oversupply is around 2 million barrels a day, less than 2 percent of global consumption. Price elasticity is also low, especially in the short run. Key uncertainties include weather conditions, unanticipated supply disruptions and geo-political factors

An unusually warm or cold Northern hemisphere winter which affects heating fuel demand has the potential to alter demand significantly. Refinery, pipeline, port or other infrastructure breakdowns can affect supply. Weather conditions also affect production from Northern facilities in Alaska, Canada and Russia. Accidents, such as recent Gulf Mexico oil spills, can change the balance in the market rapidly.

Relevant political factors include actions relating to sanctions on Iran and Russia and the outcome of civil wars in Iraq and Libya. One factor in the current supply glut was increase of 800,000 barrels a day in Libyan production. This was the result of reopening export terminals following a truce agreed between tribal militias in the civil war. The fragile truce is unravelling, with oil output dropping by around 400,000 barrels a day since September 2014. These factors have the potential to change supply significantly.

In the medium to long term, market forces, production costs and required economic rates of return on investment will assert themselves. Lower prices will increase demand and reduce supply. Investment losses will reduce production capacity limiting the ability to respond to increases in demand. But these factors will take time to work through the market.

There are a number of complicating factors. Commodities, including oil, are generally traded in US dollars. The relative strength of the American economy and anticipation of normalisation of interest rates is driving a stronger dollar. This may drive oil prices lower.

The global economy is experiencing disinflation and, in the case of some nations, deflation. Price pressures and a lack of pricing power in end product markets flow through into inputs, such as oil prices, driving them lower. High real interest rates also result in low commodity and oil prices. Interest rates are at historically low levels, near zero in many currencies. But low inflation or deflation means the real interest rate is frequently high, which drives oil prices lower. If these financial factors persist, then the downward pressure on oil prices will continue.

In the near term, baring a sudden change in supply conditions, its seems probable that oil prices are likely to be weak but volatile. But as radio talk show host George Noory counselled: “Well, with prophecy you got to see what happens”.

© 2015 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money

One Response to "Oil Shock Part 1 – “The Great Sweating”"

  1. TheRadicalBaron   April 22, 2015 at 11:35 pm

    Satyajit, great article and analysis. While I agree on the overall historical perspective you did not even mention a potential game changer, the Mexican Energy Reform. Even if the current proven reserves are not as large as the Saudi ones, the limited exploration budgets of the NOC (PEMEX) have a silver lining. The vast territorial extension of the country includes onshore and offshore reserves that conservatively could be in the range of 250 to 300 billion barrels. The documented wellhead cost of USD$10/barrel for onshore mature fields and USD$40 for deep water, are economic at this stage. If you combine the low cost with a state of the art pipeline infrastructure connecting the fields to the refining complex in Texas, you get suppl-side efficiency to the consumer market. I believe the OPEC cartel is done.