Kemp: Oil Market Mightier than OPEC

There is nothing remotely surprising about the sharp fall in oil prices over the last four months, except perhaps the timing.

The fundamental forces driving prices lower (rising supply outside OPEC from shale and sluggish demand growth as result of conservation and substitution) have been clearly visible for at least two years.

"If the shale revolution can be sustained in the United States, and successfully exported to other countries, some combination of OPEC production cuts or lower oil prices to encourage demand and forestall more investment, will be inevitable by 2015-16," I wrote last year ("Saudi Arabia must decide response to shale" May 31, 2013).

"The massive rise in prices means Saudi Arabia will face intense competition from shale," I wrote even earlier ("Saudi dominance of the oil market to fade by 2020" Dec 12, 2012).

"Compounding the problem, projected oil demand is now expected to grow much more slowly than a few years ago as a result of conservation measures."

But it didn't require a crystal ball to see that prices above $100 per barrel were unsustainable. Inexorable increases in shale production have been evident in the reports published every month by North Dakota's Department of Mineral Resources and the U.S. Energy Information Administration (EIA).

On the demand side, consumption of refined products in the United States is still more than 2 million barrels per day lower than it was in 2005, and the drop is more like 3 or 4 million barrels if population and output growth are taken into account ("Energy efficiency, bigger than shale" Sep 24, 2014).

James Hamilton, veteran oil expert at the University of California, has calculated oil demand across all the advanced economies is 8 million barrels per day lower than it would have been if it had continued growing on the previous trend ("Time for a good sweating in the oil market" Sep 29, 2014).

Prices above $100 are unsustainable because they encourage too much new supply and incentivise too much demand destruction.

OVERSUPPLY UNMASKED

For the last three years, the incipient imbalance between supply and demand was masked by a series of one-off supply interruptions which removed enough crude from the market to offset rising shale output.

U.S. sanctions on Iran coupled with civil wars and unrest in Libya, South Sudan, Syria and Iraq all helped conceal the extent to which the market was fundamentally oversupplied.

As the Energy Information Administration has repeatedly pointed out, production losses as a result of these interruptions has broadly matched the rise in U.S. shale output ("U.S. liquid fuels production growth more than offsets unplanned supply disruptions" Aug 27, 2014).

The timing of the correction (benchmark Brent prices are down more than 25 percent since June) was always uncertain.

I thought it would come a little later, starting in 2015, when the pressure from rising rival supplies and stagnating demand would really squeeze market share for Saudi Arabia and the rest of OPEC.

But the fact that the decline was triggered by resurgent oil exports from Libya, which rose from 200,000 barrels per day in June to 900,000 at the end of September, according to the EIA, should come as no surprise.

Since it was only supply interruptions that had supported the market above $100 for the last two to three years, any resumption was bound to trigger a sharp correction, as the EIA has noted ("Lower demand, higher supply drive oil prices to lowest level since 2012" Oct 8, 2014).

OPEC'S LIMITED OPTIONS

In this context, it is logical for Saudi Arabia, and other members of OPEC, to resist calls for production cuts to reverse the slide in prices.

Even if OPEC could cut production enough to push prices back above $100, it would just encourage more shale drilling and the continued stagnation of demand, making the problem worse.

Saudi Arabia, and OPEC, would be sacrificing market share to support prices at an artificially high level, and within a few months, or at most a year, even deeper cuts would become necessary.

The lesson from the 1980s, when Saudi exports shrank from 10 million barrels per day in 1980 to less than 3 million in 1985, and OPEC's combined production halved from 30 million to 16 million, is that no amount of cutting can support prices when supply outside OPEC is growing strongly and demand is weak.

In the early 1980s, OPEC was wrong-footed by rising output from the Soviet Union, China, Alaska and the North Sea, as well as substantial conservation measures and switching to cheaper fuels like natural gas and nuclear, all of which were basically a delayed response to the oil shocks in 1973 and 1979.

In the early 2010s, OPEC has again been caught out by rising production from shale and a substantial conservation drive, especially in the United States, which are the lagged response to the quadrupling of oil prices between 2002 and 2012.

The parallels between the two periods are eerily close, confirming that if history does not exactly repeat itself, it certainly rhymes.

BATTLE FOR MARKET SHARE

As Jorge Montepeque, the director of market reporting for Platts, likes to remind everyone: the best cure for high prices is high prices. But the reverse is true as well. The best cure for low prices is low prices.

The events of the early 1980s were traumatic for Saudi Arabia, which was hit by a combination of falling prices and shrinking export volumes, the worst possible combination.

To prop up the market, the Saudis reached out to Britain for help. Improbably, Prime Minister Margaret Thatcher's free-market government briefly put pressure on North Sea oil producers not to cut their prices, as Shell insider Ian Skeet later recalled ("OPEC: Twenty-five years of prices and politics" 1988).

When Norway refused to follow suit, and the strategy failed, and other OPEC members continued to cheat on their quotas, the Saudis stopped cutting output to support prices in 1985 and switched to netback pricing to regain their lost market share, in effect guaranteeing refiners a set margin in exchange for buying Saudi oil.

Netbacking and the resulting volume warfare sent prices sharply lower, at one point dipping briefly below $10. In the end, the pain proved too much, and the cartel found new discipline, with members agreeing new quotas and adhering to them, more or less, in 1986.

THE CURE FOR LOW PRICES

But it was not quotas, or renewed cartel discipline, which ended the crisis. Both inflation-adjusted prices and OPEC's market share remained much lower throughout the late 1980s and the 1990s than they had been before the crisis. Saudis Arabia's budget remained in deficit for almost two decades as a result of the drop in revenues.

Instead, it a long period of low prices gradually restored balance between supply and demand. Low prices discouraged investment in supply: no major new oil formations were developed after 1985 until shale came along 20 years later. Tens of thousands of highly skilled petroleum geologists and engineers were laid off in the 1990s in a bloodbath of cost-cutting.

And consumers grew complacent. Oil never recaptured its former market share in heating and power generation. But in the transport market, cars became larger, heavier and more powerful as consumers forget the pain of 1973 and 1979.

In the United States, new cars and light trucks achieved 22 miles per gallon in 1987, up from 15.9 mpg in 1979, but by 2004, that had slipped to 19.3 mpg, according to the Environmental Protection Agency.

The average weight of new vehicles climbed from 3,221 pounds in 1987 to 4,127 lbs in 2011. Engine power doubled from 118 horsepower to 230 ("Light Duty Automotive Technology, Carbon Dioxide Emissions and Fuel Economy Trends" 2014).

It took almost twenty years, from 1986 to 2003, for all the demand lost to be bought back and spare production capacity inherited from the early 1980s to be used up, but it when it finally happened, the conditions for the next price surge had been put in place.

The current situation is less serious than the one that confronted OPEC in the 1980s and 1990s. Oil prices have been unsustainably high but the margin of overvaluation is much smaller. There is excess supply, but much of it is incipient rather than realised. The market should therefore rebalance far more quickly than after 1986.

But the longer that the imbalance between supply and demand persists, the worse it will become and the deeper and longer the eventual correction that will be needed.

For that reason, the only sensible strategy for Saudi Arabia, and OPEC generally, is to focus on market share and allow prices to decline to the point at which they slow the growth in non-OPEC output and lessen the drive for energy efficiency.

As Henry Flagler, one of the co-founders of the 19th century monopolist Standard Oil, might have said: the oil market is in for a good sweating (again).

By John Kemp