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The Oil Price: How Low Is Low?

The Oil Price: How Low Is Low?

With West Texas Intermediate (WTI) and Brent close to their January 2015 lows some readers are wondering how these lows compare with historic lows when the oil price is adjusted for inflation (deflated). BP just happen to provide an oil price series that is adjusted for inflation (Figure 1). The data are annual averages and based on Brent since 1984. Annual averages conceal the extreme swings in price that tend to be short lived. At time of writing WTI front month future contract was $44.42 and Brent front month future was $49.92.

Figure 1 The blue line gives the annual average oil price (Brent since 1984) in money of the day and the red line adjusted for inflation expressed in $2014. Three large spikes in the oil price are evident in the 1860s, 1970s and 2010s. It is notable that the magnitude of each spike is similar, of the order $100 to $120 (adjusted to 2014 $). The 1860s and 1970s spikes were followed by long bear markets for the oil price, lasting for 110 years in the case of 1864 to 1973. Related: Congress To Lift Oil Export Ban Next Month?

To understand what was going on 1861 to 1973 I suggest readers read The Prize: The Epic Quest for Oil Money and Power that earned author Daniel Yergin the Pulitzer Prize. It is a tremendous read. Most of us are however, more interested in how today’s prices compare with recent slumps, most notably the slump of 1986 and 1998 (Figure 2).

Figure 2 The main events, Acts 1 to 6, are described briefly below.

To get straight to the point. Brent will need to fall below $30 to match the lows seen in 1986 and to below $20 to match the lows seen in 1998. Related: Frack Now, Pay Later: A New Era In U.S. Oil?

WTI in particular is trading close to its support level of $43.39 marked on 17 March 2015. If traders push the price below that level then the price could fall a lot lower for a brief period. At the fundamental level, supply and demand need to be rebalanced and the main problem is over-supply of LTO from the USA and of OPEC crude depending upon which way one views the problem. The recent price action since September 2014 has been brutal on producers but not yet brutal enough to remove the 3 million bpd over supply from the system.

I do not believe that the white knight of increased demand is about to gallop over the hill and therefore see a risk of substantially lower price in the months ahead. Colleague Arthur Berman has a somewhat more upbeat perspective.

Historic Fundamentals

The large scale structure of oil price history is shaped by supply and demand driven by both political dimensions and industry action and innovation. The main landmarks are:
1. The 1973 Yom Kippur war followed by the 1974 oil embargo. The amount of crude withheld from market by OPEC was relatively small (Figure 3) but was sufficient to cause the first oil price shock.

Figure 3 Oil exports for selected OPEC countries based on BP 2014.

2. The 1979 Iranian Revolution followed by the 1980 Iran-Iraq war led to the second oil shock. The price reaction at this time did not reflect the fundamentals of supply and demand and gravity soon took over sending the price down again in the years that followed together with OPEC market share.

3. The 1986 slump was caused by OPEC reasserting its authority and trying to reclaim market share that led to a prolonged bear market that culminated in 1998 when the world was awash in oil. Related: When Will Oil Prices Turn Around?

4. The low point since the first oil shock was marked by $10 oil (money of the day) in 1998. I remember it well since I was running an oil related business at that time. This heralded in a new era for the industry that went through a massive restructuring with many household names being swallowed up by the super-majors.

5. The commodities Bull Run that began around 2002 that lasted to 2008 or 2014 depending upon one’s perspective had complex reasons from a perceived peak in conventional oil production, the Chinese industrial revolution, expansion of debt, zero interest rate policy (ZIRP) and bubblenomics. Rune Likvern gives a good account of the links between the oil price and economic policies.

6. The 2008 financial crash brought an end to phase 1 of the Bull Run that was re-inflated by OPEC cutting supply and QE blowing more liquidity into the bubble until 2014.

Rune argues that an end to QE in the USA is implicated in recent global currency adjustments and the rout of the oil price and that is surely part of the story. But the OPEC policy of maintaining market share and over supply of either LTO or OPEC crude have also played a prominent role in Act 7 that is still being played out and still has a way to run before a new market equilibrium is reached.

By Euan Mearns

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