Michael Lynch: Oil Markets 1986 Or 1998?

Oil markets have started with a bang or, more precisely, an implosion with prices hitting levels not seen since pre-peak oil days (i.e., 2003, especially if you ignore December 23, 2008) and causing havoc in not just the oil industry but commodity and equity markets and even some currency markets. For the youngsters, this probably resembles the apocalypse, a once-in-a-lifetime catastrophe that could spell the end, or at least smaller bonuses.

The question remains as to where the bottom is, and what is a sustainable price for the medium and long-term. For the former, which is a short-term question and much more influenced by trader psychology, I often cite the case of two major market turns, in 1998 and 2008, both “predicted” by The Economist magazine (sort of). As the late Matthew Simmons often pointed out, the oil price in 1998 began to rise shortly after the infamous “Drowning in Oil” cover on that magazine, in which oil prices were predicted to remain at $12/barrel for an extended period.

The magazine published an apology later, “We Wuz Wrong,” and went so far as to feature said Matthew Simmons in an interview in 2008, just as oil prices were passing $130/barrel. In it, he predicted that “The high priest of “peak oil” thinks world oil output can now only decline.”  Within days, the oil price peaked and began its decline to sub-$40/barrel levels. The lesson: The Economist is a negative predictor of price trends.

But the major point that The Economist, and many others, missed was that the 1998 oil price decline occurred from a normal oil price level (roughly $30 in current dollars), meaning it very quickly approached marginal cost levels. In 1986, by contrast, the pre-crash price was over $50/barrel in current dollars and although many argued that even that level was too low to cover costs, this reflected cyclical inflation in costs rather than a depletion of the “easy oil”. The same, arguably, is true today.

Oil Prices in 2010$

Many have misinterpreted the interaction of costs and prices, thinking that high costs will provide a floor under prices, at least in the long-term. (Christophe de Margeri, who implied I was an idiot for suggesting a sustainable oil price was $50-60 in 2012, fell into this category.) The mistake was interpreting the tripling of costs in the 2000s as due to the end of the “easy” oil instead of cyclical inflation due to high prices and soaring upstream investment. Costs are already declining with lower oil prices and upstream activity, and will result in much lower “marginal cost” over the long term.

Revenue needs have also been cited as implying a high floor price for oil, but while they are influential, they are hardly determining and often misunderstood. (When my daughter was little, I often had to explain that she didn’t “need” a doll, she “wanted” it.) One difference now is that many of the Gulf countries, at least, have amassed substantial cash reserves, whereas in 1986, most had run through the bonanza of the Iranian Oil Crisis, spending their income (and then some), assured by the many predictions of ever-rising prices from the vast majority of energy economists. (Morry Adelman, my mentor, was often derided for suggesting prices would decline.) And budgets in many Gulf countries have more flexibility than assumed: most include a boost in spending in response to the Arab Spring uprisings, as well as large capital projects and armaments purchases, all of which can be reduced and/or delayed, lowering the oil price level needed to meet revenue “needs”.

Countries like Iran, Nigeria, Russia and Venezuela are certainly suffering from the drop in income, but each was suffering at $100 a barrel as well. Nigeria’s problem has long been the loss of revenue to corruption, while the other three have been burdened not only with corruption but deficient, if not destructive, economic ideologies. The possibility of political unrest is increased by lower oil prices, and varies from country to country, but should not be exaggerated.

Indeed, the end of the Soviet Union came after the 1986 oil price collapse, which cut their foreign exchange earnings by nearly half, but their need of money to buy grain and other food reflected the reliance on collective farms instead of private enterprise. And other producers survived a decade and a half of “low” oil prices from 1986 to 2000, because lower oil revenue has negative political consequences but most governments have coping mechanisms. (A subject for a later post.)

So, the price drop to $30-40/barrel represents a 1986-style correction to a price ‘boom,’ and is unlikely to be reversed by market fundamentals, at least in the near term. A return to $80/barrel, as many predict, would involve some major changes to the supply map which are all but impossible, short of political interventions. (Again, subject for a later post.) That said, the abrupt change in prices (and oil revenues for producers) is extremely disruptive and there is every chance that political disturbances in Venezuela or the Gulf could see prices rising, if only temporarily.

Forbes