The history of oil in reverse

The global benchmark, Brent crude, joined the American one, West Texas Intermediate, below $US40 a barrel this morning in a snowballing reaction to last week’s capitulation by OPEC to the US and Russia.

It’s also less obviously a reaction to this week’s climate change talks in Paris, which are heading towards a deal despite Saudi Arabia’s best efforts to scuttle it.

If the world’s nations agree to limit the increase in temperature to 2 degrees above pre-industrial levels by 2100, it will require radical decarbonisation and a big switch to electric vehicles and solar power, although that was probably going to happen anyway.

The immediate cause of the collapse in prices to below $US40 is a supply glut brought about by the OPEC cartel’s futile attempt to retain its market power.

The same thing is happening in iron ore: the cartel of BHP, Rio and Vale have attempted to drive Chinese producers out of business, but so far it hasn’t worked and all they have done is manage to cut their own revenues.

OPEC’s efforts are directed at the American frackers, which will become the “swing producers” if Middle East production is cut back.

That’s why OPEC maintained production in 2014, thereby halving the price, and why the cartel increased its production ceiling last week from 30 million to 31.5 million barrels a day, which has led to another leg down in the price this week.

Ironically, OPEC was born in the same conditions: a supply glut and a battle with the Americans.

In the 1950s, as now, oil demand was growing but supply was growing faster. As a result, discounting was rampant — exporting countries were selling at bigger and bigger discounts to the official, or “posted” prices.

It was exacerbated by the arrival of a new producer into the market — not the American shale producers, as it is this time, but the Soviet Union. Stalin had ploughed a huge amount of money into rebuilding the Soviet oil industry and as a result between 1955 and 1960 its output doubled.

In those days the oil market was controlled by the “Seven Sisters”, that is the seven American and European oil companies that held the concessions and managed the distribution of all oil from producing countries.

In 1959, in an effort to deal with Soviet production, British Petroleum unilaterally cut its price, thereby slashing the national revenues of oil producers.

That was on the eve of a scheduled Arab Oil Congress meeting in Cairo that year. It turned out to be a crowded, angry meeting; alliances between producing countries were established that would eventually lead to a formal cartel.

The final trigger came in August 1960, when Standard Oil of New Jersey (which became Exxon), without any warning, announced price cuts of up to 14 cents a barrel in the posted prices of Middle Eastern crude — a 7 per cent reduction.

The other companies all followed suit, although as Daniel Yergin wrote in “The Prize: The Epic Quest for Oil, Money and Power”, they did so “without any enthusiasm and in some cases with a good deal of alarm”.

On September 10, 1960, representatives of the major exporting countries — Saudi Arabia, Venezuela, Kuwait, Iraq and Iran — arrived in Baghdad for a meeting and over four days of talks they established the Organisation of Petroleum Exporting Countries.

At first the oil companies were apologetic and conciliatory, then during the entire 1960s they tried to ignore OPEC and assert their rights inherent in their concessions.

But by the end of the 1960s the number of cars in the world had changed the balance of energy power irrevocably.

In the US the number of cars increased from 45 million in 1949 to 119 million in 1972. Outside the US the increase was even greater — from 19 million to 161 million.

Global demand for oil surged and created the background for the 1973 OPEC embargo against the US, Japan, Canada, UK and Netherlands in response to their support for Israel in the Yom Kippur War of that year.

The crude oil price went from $US3 to $US12, and the world economy was changed forever.

In the second half 2014, there was a “reverse oil shock”: the price fell from $US105 to $US45 as OPEC tried to retain its market share against the new US producers as well as Russia and Iran.

In fact many are now saying that OPEC is effectively dead because there is no longer anything to distinguish its members from non-OPEC producers. At the very least, the Saudi-led cartel is in for a long and brutal siege that will cost them plenty.

The world is awash with oil. Remember “peak oil”? It is merely a distant fantasy now with 100 million barrels stored in floating tankers and inventories in the US and China at bursting point.

And although the rig count in the US fracking industry has fallen 60 per cent over the past 12 months that would rise quickly if OPEC cut production. In addition Iran’s production is expected to crank up next year.

And then on top of that will come the effect on long-term demand of this week’s climate change deal in Paris.

World leaders have been talking about climate change for 23 years and have so far done next to nothing about it, culminating in the debacle in Copenhagen in 2009.

But in Paris this week it looks like a genuine deal is in prospect that will limit the rise in temperatures to 2 degrees. There has even been talk of 1.5 degrees.

Saudi Arabia has apparently been working hard behind the scenes to scuttle the deal, but without success.

The carbon emissions reductions needed to meet the Paris target will be drastic, and probably require the complete extinction of the coal industry and the reversal of that increase in petrol-burning cars that occurred between 1949 and 1972 that handed so much power to OPEC.

Electric vehicles were always going to take off anyway, but tough emissions standards from a deal in Paris will speed that up.

In addition there will soon be breakthroughs in battery technology that will make electric cars cheaper and go a lot further between charges, and at the same time make solar power viable.

The world is on the threshold of an energy revolution and, as usual, markets have been anticipating it, at the same time as reacting to the short-term supply glut.

Markets usually overshoot and oil is no exception, so there will probably be violent spikes up in the months ahead.

But with chronic oversupply of oil and tight restrictions on the burning of fossil fuels out of the Paris climate conference, Goldman Sachs’ dire prediction of $US20 for the price of crude oil could well come true.

theaustralian.com.au