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Steve Brown

Steve Brown

Steve Brown is a petroleum engineer with over thirty years of experience with BP, Halliburton, Challenge Energy, Petrofac, Exile Resources, Setanta Energy and now The…

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Why Today’s Oil Bust Is Not Like The 1980s

Why Today’s Oil Bust Is Not Like The 1980s

Back in February 2015, Bob Dudley, BP's CEO, said in a Bloomberg TV interview that the fundamental supply and demand picture reminded him of 1986, and he feared we could go into a period of lower oil prices perhaps staying in a range below $60/bbl for as long as three years. He added "It will be a long time before we see $100/bbl again."

Here in late August, with WTI having dipped below $39/bbl and with Brent prices under $44/bbl, Bob is looking kind of prescient and many more analysts and talking heads have jumped onto the "lower-for-longer" bandwagon. But I think the analogy he drew between 1986 and 2015 is flawed.

Here's why.

In 1986 we had just been through two oil price shocks that saw the OPEC cartel first discover its power and then overplay its hand quite spectacularly. Let me start with a little explanation of the data on the charts below. Everything I say about the oil price is drawn from analysis of data so it is worth understanding that data before diving into the conclusions. The green zone is the rest of the world (the likes of the North Sea, Mexico, China and so on); then the red area, somewhat appropriately, represents the Former Soviet Union; the U.S.A and Canada is in yellow; and finally the blue is OPEC, with OPEC's spare capacity in pale blue sitting above the sum of total world production. World oil consumption (less biofuels) is the dotted line and the annual average oil price in 2014 $/bbl is the solid line.

Consumption doesn't equal production because, well, just because. BP, whose data I am using, says "Differences between these world consumption figures and world production statistics are accounted for by stock changes, consumption of non-petroleum additives and substitute fuels, and unavoidable disparities in the definition, measurement or conversion of oil supply and demand data." So as I said, just because. Before the eighties the consumption figures track just below production, after that they typically track just above production. Related: Oil Prices See A Modest Rebound As Some Bullish Signals Appear

Oil price, production & consumption data BP; OPEC spare capacity EIA

Before the first oil shock in the early seventies the oil price depended mostly on the Texas Railroad Commission and the whims of the Seven Sisters, but then in 1973 the Arab oil embargo caused a jump in prices and OPEC was in charge. The 1973 increase in oil prices dented world economic growth, though not to the extent that OPEC lost all that much market share. It took the second leap in prices in 1979 to do that. After the oil price climbed above $100/bbl (in today's money) world oil consumption fell pretty rapidly, and on top of that OPEC's market share fell from 49 percent in 1976 to 28 percent in 1985. A lot of that pain was borne by Saudi Arabia whose market share fell from 15 percent to just over 6 percent. With that historical context, you can understand why defending market share matters to OPEC and the Saudis.

By 1986 with a huge overhang of excess capacity, and OPEC desperate to rebuild its market share, the oil price collapsed, only rebounding a little when OPEC spare capacity was decimated by the Gulf War. In time, low oil prices stimulated growth in oil consumption, but it took nearly two decades before "low prices cured low prices" and there was another seismic shift in the markets.

It wasn't until the early years of this new century that growth in consumption began to outstrip growth in production capacity (helped along by the loss in capacity caused by another Iraq War). That shift in the market dynamics started a march up in oil prices which culminated in a cargo, or maybe a paper barrel, changing hands at $147/bbl. You can see in this second chart that prices tend to be higher when oil consumption exceeds this proxy for world production capacity (when the dotted line is above OPEC spare capacity) and that oil prices start to head lower when capacity exceeds consumption. It seems that oil is in fact not a special commodity and that it just obeys the laws of supply and demand like any other product. Related: Does Arctic Drilling Have A Future With Sub $50 Oil?

Oil price, production & consumption data BP; OPEC spare capacity EIA

Of course the oil price does have the magical power of altering world economic growth but that is just how the price mechanism works when there aren't readily available substitutes, as in the transport fuels market.

So why is 2014 not like 1985? Well, in 1985 OPEC's market share was less than 30 percent, down nearly 20 percent points from a decade previous, during which time oil prices had averaged over $70/bbl in 2014 money. Saudi Arabia produced just 3.6 mmbbls/day in 1985, a dramatic decline from the 10 mmbbls/day it had produced just four years previously. For the Saudis this was a devastating loss of revenue and more importantly loss of prestige and control of the market. Not an experience to repeat.

Conversely, at the end of 2014, OPEC's market share was still over 40 percent, less than 2 percent down from a decade before, during which time oil prices had averaged over $90/bbl. The world has changed from the eighties to now; back then even moderately high oil prices reduced world oil demand and destroyed OPEC's market share, nowadays both oil demand and OPEC's market share has been pretty robust to $90/bbl oil. Related: Oil Prices Driven Lower By Everything Except Fundamentals

However, the lessons of the eighties were painful for OPEC so when market share started to decline just a little, pre-emptive action to snuff out further growth in U.S. Light Tight Oil was perhaps inevitable.

So what is next, and when will prices recover?

OPEC has been expecting both supply and demand to react to the lower oil price but the world economy is looking a tad shaky so the demand response may take longer than they might have hoped. If recession delays a demand drive price recovery, it seems to me that one of two things might happen to raise the oil price: some unforeseen event that chokes off a good few hundred thousand barrels per day of production could take place; or, OPEC might, in its own self-interest, ease off on its strategic over-supply of the oil market.

There is even now talk of an emergency meeting, but OPEC probably won’t act until they are sure U.S. production is firmly in decline, and they can't really be sure of that until U.S. production falls below 9 mmbbls/day. The EIA thinks that won't happen until 2016, having poked into the detail of production in the Eagle ford, Bakken and Permian, I suspect it will roll along a little sooner than that, but that might just be wishful thinking on my part.

By Steve Brown for Oilprice.com

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  • K Yamaguchi on August 25 2015 said:
    Steve,

    This was in a Reuters report that came out of few hours ago. Haven't seen any other reports of Iraq's export falling by 250,000 barrels in the 1st 17 days of August. Seems they buried the lead, if accurate.

    "A Gulf OPEC delegate said he didn't see Saudi Arabia changing strategy and that Brent may fall to $40 before recovering. Signs of lower exports from OPEC countries would be more likely to boost prices than talk of a meeting.

    Iraq's oil exports fell by at least 250,000 barrels per day in the first 17 days of August, according to loading data, making it less likely a steady rise in OPEC output will be sustained this month."

    "Reducing production will have an immediate strong reaction on the market - better than a meeting with no outcome," he said. "Calling an emergency meeting will not help at all."

    http://finance.yahoo.com/news/without-saudi-support-talk-opec-144348961.html
  • Dan on August 26 2015 said:
    I think your article is purely an analysis of data and does not look deeply enough into reasoning behind Opec/Saudi strategic decisions. While it mentions the effects of the Iraq war and loss of production (Iraq themselves caused a big drop in production by invading Kuwait) it totally ignores the current geopolitical war that is being fought and has been commented on in the media over the past few years.

    The Saudis want to see Assad fall, the Russians do not. If Assad falls, a new govt friendly to the Saudis (or less friendly to Putin) would likely permit gas pipelines to be routed through Syria to Europe, thus competing with Russian supplies. Putin wants to prevent this at all costs.

    The Saudis and the US are therefore happy to create an oversupply of the oil markets, along with a media frenzy geared to forcing oil prices lower, so that Russia's and Iran's economies are hurt as much as possible, in the attempt to either cause them to change their policies (especially Russia/nuclear deals with Iran and support for Assad) or to cause regime change.

    The current low prices have a lot to do with reported excess capacity, and we see the WTI price fall every time the EIA inventory figures show a rise, but the increase is purely down to voluntary, not necessary, imports of oil, and are not due to excess US production. This excess capacity is clearly being used as a political weapon to hurt the enemies of the US and the Saudis, not as a weapon to gain market share. That is just a smokescreen for the Saudis to hide behind. The economic losses being incurred by the Saudis will never be recovered, and they would have been best served to maintain oil prices, produce a little less, and conserve their supplies long in to the future, but that would help to strengthen the Russian and Iranian economies.

    The Saudis are now between a rock and a hard place. They have not secured (yet) any agreements with Putin to stop supporting Assad, to stop supporting Iran's nuclear strategy, not have any regimes been changed!

    The big question is just how long are the Saudis prepared to fight this unwinnable fight?

    Finally, assuming your article is correct and this is only about market share, they have also failed as the US shale industry, and probably most others, have driven down their costs, making them leaner and meaner and while there might be a small short term drop in production, they will come back even stronger in the future and take a bigger market share than before.

    Well that's my point of view and I'm sticking with it ;-)
  • Curtis on August 26 2015 said:
    OPEC can't control this one- we have a glut because the entire world is now producing oil at record production numbers
    We have an economy that's in decline despite being propped up by the Fed for the last 7 years
    Lastly- we have China markets tanking-Why are China markets tanking? The obvious answer is because the USA is not buying goods from China at previous levels.
    Why are we not buying goods at past levels?
    Well the answer is either because we are now producing them here ( which we are obviously not) or because the demand is no longer here for them ( the correct answer)
    Why no demand? Because our economy is failing ( obviously)Retailers are not making goods in past numbers for the Holiday sales, builders are not buying steel in record amounts...We are toast and the outlook for oil will be just like the 1980's with a VERY slow recovery
    OPEC knows all this because it's just common sense-Sure they dump oil on the market now in record 10 million barrel amount to hurt American producers BUT they also dump because they want to sell ALL they can at these prices because its going lower-A LOT lower IMO
    ...and this BUST will be as bad or worse than the 1980s
  • howard wang on August 26 2015 said:
    I like the comment Dan made. However, I would add some change in global economic landscape. That biggest factor is China. Chinese were riding on bikes (most of them at least) until probably 10 years ago. In Shanghai now, one has to pay the city $10,000 or more just to get a permission to buy a car before he pays for the car and all the fees, that is if he wins the bid for the permit to buy one.

    Also, India is not going to stay static. There you will see more cars thus oil needs. It will be similar in other countries and other continents. One thing remains constant: world population is growing (most like to own cars and most cars are and will be powered by gasoline due to economics and technology restraints on hybrids and all electric vehicles). Large world population also means larger consumption of all things made or derived from oil.

    So there is geo-political and there is cold hard world wide facts on economics. Our population is getting larger, poor countries are getting rich, people will consume more of everything (goods and services--transportation & travel by air, sea and land. I believe this oil price crisis presents the best investment opportunities in the decades to come. Much better and safer than the ones presented during the housing crisis. Keep in mind, mega banks stock did not and could not rebound meaningfully even after housing and financial crisis abated because of the non market risks banks had to deal with: regulatory (from fines to new restrictive regulations), class action law suits, etc. With oil, the moment oil starts to rebound, oil sector stocks will jump with nothing else to deal with. It is and will be a pure market force driven phenomenon.
  • Nick on August 28 2015 said:
    As an old hand that worked on both off shore and land rigs I can say the article only takes in account only a narrow view....supply, demand, and geo politics. In my may, the search for reserves was location, location, and location. Now the technology back in the 1980's was considered upcoming. However, since then that technology is now old. The technology now is many times superior to that time frame. It is no longer the old location aspect, even though it still has an important role, it is technology, technology, technology that is the primary driving force to extract more oil than ever before. Oil prices will "float" around the $40-$50 range for many years. I I see it simlair to the 1908's...just with less geo politics.

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