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Page added on February 6, 2015
A lesson from the history of oil
In an interview with Bloomberg TV, BP CEO Bob Dudley took a bearish view on the price of oil, noting that the present feels like 1986, when oil slumped from $30 a barrel to $10 and did not recover until in 1990. “The fundamental supply and demand does remind me of 1986 a bit, where we could go into a period in this decade of lower oil prices,” Dudley noted, adding that prices may stay in a range below $60 for as long as three years. “It will be a long time before we see $100 again.”
I agree with Dudley: 1986 is the appropriate template for today’s oil market dynamics. However, the understanding of the precedent is incomplete, and the analogy, imperfect. The differences matter.
In 1986, as in 2014, oil prices had been high for many years, and OECD oil consumption had been falling — indeed, much more after 1980 than it has since 2008. Just as in 1986, oil prices collapsed due to a supply surge, not a global recession. But beyond this, the differences are material.
After 1979, Saudi-led OPEC decided to maintain high prices by cutting production, even in the face of rising non-OPEC supply from Alaska, the US Gulf of Mexico, and the North Sea. To maintain prices, the Saudis cut production in sequential rounds, with Saudi output ultimately falling from 10.3 million b/d in 1980 to 3.6 million b/d in 1985, according to BP’s own Statistical Review. As a consequence, by 1985 OPEC had approximately 13 million b/d of spare capacity — 22% of global oil consumption. Of this, 7 million b/d was in Saudi Arabia alone. When Saudi Arabia capitulated in 1986 and switched to a volume-based strategy, this spare capacity was deployed, depressing oil prices not for four years, but materially until 2003, when the surplus was ultimately consumed. This period, from 1985 to 2003, has a name: the Great Moderation.
For BP and others, this matters. In its 2014 Energy Outlook, BP correctly anticipates that supply will increase faster than demand (something which I did not). However, BP anticipates that OPEC will cut production to maintain prices. As I wrote earlier here on The Barrel: “Discipline could depend heavily on the Saudis, [nevertheless] such restraint may prove elusive.” And indeed, Saudi Arabia had not forgotten the Lessons of ’79. As a consequence, the kingdom has refused to cut production, and oil prices have plunged as a result. However, this also implies that no massive spare capacity has been created. Indeed, discretionary spare capacity remains around 2 million b/d — all of it in Saudi — and a pretty thin margin on 92 million b/d of consumption. Consequently, when Dudley compares 2014 to 1986, he is neglecting to account for diametrically opposed Saudi policy during the current period and the lack of spare capacity today as a consequence.
Moreover, demand responded sharply in 1986. If it responded as OECD demand responded in 1986, demand would soar to nearly 96 million b/d — a 4 million b/d gain — by mid-year.
Furthermore, supply would collapse. Based on the 1986 example, some 2.4 million b/d of conventional production would be expected to roll off in the next 12-18 months at current prices. Given that shale oil production is expected to peak around mid-year, the second half of the year could see a dramatic reversal in the supply-demand equation, potentially setting up the third oil shock in a decade. It is for this reason that OPEC’s Secretary-General Abdulla al-Badri recently stated that “if you don’t invest in oil and gas, you will see more than $200″ when it comes to future oil prices.
For BP and other companies, getting the strategic context right is enormously important. If one believes oil prices will soon rebound, Dudley’s pessimistic view of the market may put excessive pressure on the company’s fabled deepwater group (notwithstanding Macondo, a tremendous collection of talent and capability). The company will over-react to the current downturn. Moreover, BP will under-react in shales and fail to sufficiently strengthen its position in shale oil during the relatively thin window when valuations are likely to be depressed.
On the other hand, if one believes in low prices for a long time, then the future of deepwater will be grim, and divesting the capital intensive (primarily deepwater) divisions of the company has to be on the table. And of course, low oil prices can only arise from continuing spectacular success in US shale oil production growth. US shale production represents three-quarters of global supply growth since 2005; without continued success in this arena, oil prices cannot remain depressed. This, in turn, suggests that BP should further expand its positions after the current spell of low oil prices has sufficiently weakened the independent US operators. By this line of thinking, the company can afford to wait before pouncing on targets.
Dudley is right. The correct precedent is 1986. But the differences with that time are as important as the similarities, and getting the analysis right will be critical going forward.
10 Comments on "A lesson from the history of oil"
Plantagenet on Fri, 6th Feb 2015 7:43 pm
The current oil glut is not going to last forever. It will be a grim period for the US shale oil biz if oil prices stay low for 3+ years, as they did in 1986, but eventually oil supply will tighten and oil and gasoline prices will start heading up again.
GregT on Fri, 6th Feb 2015 8:22 pm
These current high oil prices are unsustainable, and continue to do damage to our economies. We are still paying twice the goldilocks range for a barrel of oil that has historically kept us out of recession. Add to that the reduction in the amount of energy available in a barrel of oil, and it shouldn’t be that difficult to understand why we are rapidly approaching the end of the age of oil.
Carl S on Fri, 6th Feb 2015 11:03 pm
No really knows what the price of oil will be next month, so predicting what will happen next year is folly. While production might increase, the one major determinate is demand. The oil industry is aware that a viable replacement to the ICE vehicle is available. Every EV sold means that thousands of gallons of gasoline/diesel will not be sold. Even a decline of demand of only 1% or 2% a year is enough to keep oil price down. Every year, EV become more economic viable and most important, EV are becoming accepted as a viable option to ICE vehicles.
fred1 on Sat, 7th Feb 2015 4:56 am
remember everyone plant is a troll. plant is a troll. and hopefully it will go away
Dredd on Sat, 7th Feb 2015 5:26 am
“A lesson from the history of oil” is actually “A [shallow] lesson from [a shallow] history of oil”
The widespread use of oil was engendered by a religious belief about two turns of the century ago (The Universal Smedley – 2, The Peak Of The Oil Wars – 10).
Breathe deep.
Dredd on Sat, 7th Feb 2015 6:38 am
“Big oil companies had a poor record of finding and producing oil and gas last year, according to figures out in the past week – and big cuts in spending in response to falling crude prices could undermine their plans to turn that around.
Four of the world’s six biggest oil firms by market value – Royal Dutch Shell, Chevron, BP and ConocoPhillips – released provisional figures showing together they replaced only two-thirds of the hydrocarbons they extracted in 2014 with new reserves.
Combined, those four and industry leader Exxon Mobil posted an average drop in oil and gas production of 3.25 percent last year.
All predict their output will increase and new reserves will be added in coming years. But the 2014 results echo longer-term trends.
Over the past decade, the biggest Western oil companies have seen reserves growth stall, production drop 15 percent and profits fall by almost a fifth – even as oil prices almost doubled, a Reuters analysis of corporate filings shows.”
(Reuters, “Oil majors fail to find reserves to counter falling output”).
Kenjamkov on Sat, 7th Feb 2015 7:24 am
To fred1, I come to this site to read opinions and discussions about Peak Oil. Although I do not completely agree with everything everybody says on the subject, I am willing to listen and contribute now and then. Plant said nothing that wasn’t true, and simply calling someone a troll does not add to the discussion one bit.
There are always two sides or more to a story. Dismissing the opposing side outright is propaganda. I reserve the right to change my beliefs based on new information and evidence. If I only hear one side of a story, I will never be exposed to new information or evidence.
We can be in Peak Oil and still have a “oil glut”. There is nothing trolly about this at all. The bumpy road down the Peak is … well… bumpy. There will be huge price swings as oil supply dwindles and builds up based on supply and demand.
I usually don’t throw in my 2 cents and do not agree with every statement Plant throws out there, but there was nothing trolly here at all.
rockman on Sat, 7th Feb 2015 10:31 am
FYI: it’s been a great many years since Big Oil has been able to replace their declining reserves WITH THE DRILL BIT. Consider ExxonMobil’s acquisition of XTO some years ago. XOM always likes to brag how the replace reserves y-o-y. They don’t like to advertise the details: the XTO acquisition represented over 80% of XOM’s reserve replacement that year. I promise you: today Big Oil is licking its lips waiting for low oil prices to drive companies to the brink so they can gobble up those reserves on the cheap.
shortonoil on Sat, 7th Feb 2015 11:09 am
“It will be a long time before we see $100 again.”
If forever is a long time, yes, it will be a long time!
Comparing 1986 with what is occurring in the industry today is not a valid comparison. The market has change, oil production has changed, and the oil itself has changed. The only similarities between LTO, and OPEC production of 1986 is that they are both liquid hydrocarbons. They both can undergo combustion in an oxygen environment; beyond that their similarities diminish. Their differing molecular structures make them completely difference substances with completely different properties. Attempting to construe what is happening today to what happened in 1986 is closer to Voodoo than science. Beginning with a false assumption is most likely going to produce a false result.
Given that shale oil production is expected to peak around mid-year, the second half of the year could see a dramatic reversal in the supply-demand equation, potentially setting up the third oil shock in a decade.
If shale production was even close to the OPEC production of 1986 a drop in shale production could create an oil shock. It is not. Because there is little, or no energy produced from the consumption of LTO a drop in its production will merely reflect an equal drop in demand. It takes a barrel of oil to produce a barrel of LTO. The two cancel with some time lag. The supply demand equation is unaffected, and prices will not advance because of it.
And of course, low oil prices can only arise from continuing spectacular success in US shale oil production growth.
Low oil prices are not the result of US shale oil production growth, they are the result of declining consumer affordability. As oil’s ability to power the economy declines its value declines. That occurs because the energy content of a unit of oil is fixed by its molecular structure, while the energy needed to produce it increases. The energy remaining for the rest of the economy is diminished. Because general economic activity is dependent on energy availability, and the energy from petroleum is necessary to power transportation, declining availability results in declining demand. Prices then fall.
Growing inventories that are suppressing price are not a cause, they are an effect. As high cost production is taken off line the demand it creates to produce it declines. Inventories change little; what does not go in, is now balanced by what is not coming out! High inventories are created by the lack of affordability from the general economy. This is a situation that will continue after shale has become nothing more than a historic marker. Long term prices will continue to fall.
As long as analysts continue to use antiquated, now defunct assumptions they will continue to come to the wrong conclusions, and that is leaving us continually unprepared for the inevitable demise of the oil age.
http://www.thehillsgroup.org/depletion2_022.htm
GregT on Sat, 7th Feb 2015 2:56 pm
Worth repeating:
“Low oil prices are not the result of US shale oil production growth, they are the result of declining consumer affordability.”
For the life of me, I don’t understand why this is so difficult for some people to understand.
On second thought, sometimes I wonder how some people are able to tie their own shoelaces……..