Why oil booms and busts happen

So very different, so very the same

This brief oil market history illustrates the substantial difference between what transpired in 1979-1985 and what happened between 2005 and 2014. While the 1980s oil bull market was an unquestionably manipulated market that was bound to collapse at some point, the 2000s oil bull market was mostly driven by market fundamentals. The resolution to the last oil bull market was delivered by market forces as high prices unleashed new sources of supply, namely U.S. shale oil. This was different from the 1986 oil price collapse which was triggered by OPEC ceasing its doomed effort to artificially inflate oil prices.

Yet, OPEC hands are not completely clean in this price collapse episode. The oil price collapse of 2014 was compounded in 2015 by the arrival of geopolitically restricted oil from several OPEC countries. Iraq increased its production by 650,000 bpd in 2015. This supply should have been added to the market many years ago, but due to decades of turmoil, this oil only made it to the market last year. Saudi Arabia’s decision to bring in some of its spare capacity to the market (450,000 bpd production increase) last year also added to the oversupply situation that was created by market forces.

Additionally, politically restricted oil from Iran is being introduced to the market in 2016, thus yet again contributing to the oversupply. The sizable increase in Iraqi, Saudi and Iranian oil exports to the market in 2015 and 2016 has created (unintentionally or intentionally) the reverse of the OPEC price manipulation episode from 1979 to 1985. This time oil prices are being forced lower by a geopolitical oil supply increase that has little to do with market supply and demand fundamentals; just as OPEC aggressively withdrawing oil supply from the market in 1979 to 1985 had nothing to do with supply and demand fundamentals.

What now?

The surge in shale oil production between 2010 and 2014 was the trigger to this oil crisis, and thus a reduction in non-OPEC supply through a reduction in shale/global oil capex is a proper response to shale’s oversupply. This is how free markets balance themselves.

However, the arrival of the above mentioned geopolitical oil has interfered with the natural balancing mechanism. As oil prices overshot to the downside (and stayed low) due to the arrival of the geopolitically constrained non-market sensitive oil, the O&G industry has been forced to under invest in future oil supply as cash flows dried up and financing costs skyrocketed. The extent of under investment in shale has even been more severe with capex cuts averaging double the global average.

The substantial capex-to-supply lag for most of non-OPEC oil and OPEC’s unwillingness to restrict production or gradually ease back the increase in geopolitical supplies has forced an undue burden on shale/tight oil to balance the market on its own. Yet the shale balancing mechanism is far from perfect, shale while relatively fast moving in comparison to other sources of supply, is still a much less efficient balancing tool in comparison to OPEC. This in turn means the market is lacking the proper tools to balance itself in a timely manner in order to avoid a supply crisis down the line, as the ongoing large capex cuts flow to all non-OPEC supply (as well as some OPEC supply) through higher decline rates, and deferred or cancelled greenfield supply projects.

This delayed rebalancing caused a large build up in global inventories; those excess inventories could act as a shock absorber of sorts once supply undershoots, but it remains unclear whether excess inventories alone or in combination with OPEC will be able to compensate for an eventual dual collapse of both shale and non-OPEC supply in the context of sustained demand growth.

Conclusion

This oil boom-bust cycle is not a repeat of the 1980s, however the arrival of shale oil to the global oil scene has created a new oil pricing reality. Nonetheless, it is highly unlikely that this new oil reality is anywhere close to $30 or $40 a barrel as the futures curve is indicating and many forecasters are forecasting.

Outside of Iran and Libya, OPEC is producing close to its maximum capacity, with little prospect of a sizable increase in supply over the next several years. In essence, OPEC alone is not in a position to compensate for shale and non-OPEC declines as well as meet future demand growth. Yet, for shale and non-OPEC to assist OPEC and grow a price in the $60 to $70 range is most likely required to incent the development of marginal oil reserves.

By 2017 as global demand and supply come into balance, and inventories start to draw oil prices may snap back substantially above the $60-$70 price range as the market transitions from a flood to a drought at some point next year, however once the next price spike period settles down as shale production catches up to demand once again, prices will likely settle in the $60 to $70 range long term, and remain there until the next noticeable change in demand/supply fundamentals or until the arrival of unforeseen geopolitical events.