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By Robert Rapier on Jun 4, 2013 with 10 responses

About Those Plunging Oil Prices

Over the past three weeks, there have been numerous headlines insinuating that a freefall in oil prices is underway. Last week I read that the various causes were a slowdown in China’s economy, OPEC’s decision not to cut production, and America’s growing oil production. Based on the headlines, one might suspect that we were right in the middle of a major bear market for oil.

Just how far had the price of West Texas Intermediate (WTI) fallen? All the way to $92 a barrel. Keep in mind that WTI opened 2013 at $93.14 a barrel. Since then it has traded between $98/bbl and $87/bbl. (In my Five Energy Predictions for 2013, I predicted that the price of WTI would average less this year than last year, and that the Brent-WTI differential would narrow. To date both predictions have proven to be accurate).

According to the US Energy Information Administration (EIA), the weekly average price of WTI this year traded below $90 only once. The week ending April 19th the average price was $88/bbl. Over the past 12 months, the weekly average has traded in a range of $17/bbl. The low took place during the week ending June 29, 2012 at $80.33 and the high occurred the week of Sept. 24, 2012 at $97.56. The weekly average price of WTI over the past 12 months has been $90.95. So despite the bearish headlines, WTI is still trading above the average over the past 12 months.

Over the past 2½ years, the average weekly price of WTI traded below $80/bbl only once. During the week ending Oct. 7, 2011 the weekly price averaged $79.43, but then climbed back above $100/bbl within two months. To get consecutive closes below $80/bbl, we have to go back nearly three years to the end of September 2010.

Following the oil price crash in 2008, there was some weakness in early 2009 that for a short time saw weekly averages in the $30’s and $40’s, but by October 2009 the price had once again reached $80 despite a severe economic slowdown.

Typically the cycle of oil prices goes like this. High oil prices result in increased spending on new projects by oil companies. But high prices also slow the economy, reducing demand for oil in the process. This combination causes a supply surplus that leads to plunging oil prices and lower investment in new oil projects.

This is a cycle that has been repeated many times, but I believe this cycle will ultimately come to an end because I don’t believe the oil companies will always be able to build out spare capacity to stay in front of growing demand.

Over time the lower prices brought on by the supply surplus act as a stimulus to the economy, and demand — and in turn oil prices — pick back up. Because of the underinvestment by oil companies during the period of low prices, we often see an increase in demand at a time when the oil industry isn’t increasing supply. Thus we return to the oil price spikes that slowed the economy in the first place.

But the 2008-2009 bust was unusually abbreviated. True, prices did plummet, but they didn’t stay down long. Here is why:

oil consumption 1965-2011

Historically global demand was dominated by the US, and while the US and EU both saw decreased demand as a result of the higher prices, demand in every developing region in the world continued to grow. Thus, unlike previous oil spikes, global demand continued to climb and the oil industry was unable to build out the kind of spare capacity that had taken place in the face of previous price spikes.

Between 2000 and 2011, global oil consumption increased by more than 11 million barrels per day, but the development of additional production capacity did not keep pace. This eroded spare capacity in the global oil market, which led to much higher prices and greater volatility.

global oil production 1965-2011

A number of agencies are predicting much lower oil prices in the coming years. I have been hearing these predictions regularly since 2005. Daniel Yergin, author of the Pulitzer Prize-winning book on the oil industry called “The Prize” and one of the most highly-respected analysts in the industry, consistently underestimated the price of oil during the past decade before recently reversing direction.

But I do agree with the sentiment that supply is likely to expand for several more years. It’s just that demand is going to expand as well, and existing fields will continue to deplete. In an interview conducted last year with former Shell president John Hofmeister, he corroborated my thesis:

“In 2005 China needed about 5 million barrels per day (bpd) of oil; in 2011 China needed 10 million bpd of oil; by 2015 China will probably need 15 million bpd of oil. And that kind of tripling of demand in China, augmented by significant additional increases in daily demand from the rest of the developing world, including India and the fact that OPEC has been largely flat in its production and its inability to create spare capacity for most of the last decade is behind surging prices.”

Oil depletion reduces production in existing fields by 4 million to 5 million bpd each year, which means it takes that much new oil development just to maintain global production rates. Mr. Hofmeister summarized the problem as “We have not been able to keep up with demand growth and the decline rate simultaneously.”

However, over the past few years tremendous investments have been made in finding and developing new sources of oil, and growing demand will not as easily erode spare capacity as in recent years. This is why I have predicted that oil is likely to trade in a range — perhaps as low as $70 up to maybe $120 for the next few years. Some may feel that it is unlikely that oil could fall to $70. After all, it’s been three years since the price of WTI was at that level. But if Iran capitulates on its nuclear program, escaping the related trade sanctions, a lot of oil could hit the market, and certainly the expectations of oil traders could drive prices down in a hurry in that situation.

Link to Original Article: About Those Plunging Oil Prices

By Robert Rapier. You can find me on TwitterLinkedIn, or Facebook.

  1. By Andrew Holland on June 4, 2013 at 4:57 pm

    Robert – great article, I couldn’t agree more. I especially am bullish on non-Chinese Asian demand. China’s gone up so much that there’s limited room left to run, but I see the next wave of demand coming from place like Indonesia, the Philippines, and Vietnam.

    Anyone who thinks that a boom in North Dakota production is enough to offset these coming demand increases hasn’t looked at the numbers enough.

  2. By Benjamin Cole on June 5, 2013 at 3:11 am

    Above $80 a barrel, there is hardly an oil field in the world that won’t make money. Meanwhile, global demand is flattish for crude above $80. It looks like Japan, USA and Europe will be on permanent downslopes.

    Huge (and I mean huge) imponderables out there, all due to man, not geology.

    Iran and Iraq? They could produce 20 mbd in 10 years, or zero. Venezuela? Saudi Arabia? Mexico? Libya? Russia? Nigeria? We are takin 10-30 mbd swings in production, depending on how man behaves.

    Meanwhile, China. But what if China mandates PHEVs? They did mandate electric bikes.

    The PHEV technology is doable, we know that from the Volt. Commercial? Not sure—but then, China is not always about commercial.

    My guess is that RR is right, we are in a sweep spot that will last, or slowly drift down in price, for a long time. I suspect eventually, and we talking decades, the world will move to other options. Oil has proven unreliable, and subject to spikes, and possibly is too expensive.

    BTW, the “world prices will skyrocket, but domestic production can’t last” scenario is mutually exclusive. Pick one of the other.

    • By armchair261 on June 7, 2013 at 2:55 am

      “Above $80 a barrel, there is hardly an oil field in the world that won’t make money.”

      I don’t think this is really true. There is always a margin, regardless of price. Reducing it to simplest terms, think of a graph with the x axis being minimum commercial field size and the y axis being oil price. You have a line sloping down to the right. As prices go up, companies will tend to move to the left on the x axis: they pursue more and more small projects that wouldn’t have been done in a lower price environment. At the same time, drilling activity heats up. Lease costs go up. Demand for skilled staff and therefore salaries go up. Drilling rig day rates and well costs go up.

      We’ve looked at several projects that don’t work at $80 or even $100, because in the current cost environment, their rates of return are insufficient. Or alternatively, we perceive that the risk of failure is too high to bear in exhange for the prize at $80. These are projects that no one would have even considered at, say, $40 oil (when someone probably would have said you can’t lose money at $40 oil), yet now at $90+ companies are out there trying to make marginal projects like this work.

      In terms of most existing production and in volumetric terms, and for most large companies, you’re probably right. But it’s at the margin where a lot of new activity occurs, in the form of wells, jobs, and new production, and at the margin profit at $80 is not at all guaranteed.

  3. By Jennifer Warren on June 5, 2013 at 12:29 pm

    I’m with you Andrew. U.S. production is curtailing our own imports, not the thirsty growing economies of the non-OECD. Great piece Robert. Indeed demand shocks and supply shocks clobber prices, according to research I’ve seen, with a multiplier effect. This research suggests a 10X multiplier effect either way. I’ve included the bit about China’s demand too.

    …”The demand for oil by China does not grow at par with its economic
    growth. It swings from say 2% to 17% (with a 5% standard deviation). Demand
    shocks work similarly to supply shocks. If demand falls short by 2%, then price
    falls by 20%. Conversely, if demand rises 4%, then price rises 40%.”

    • By Robert Rapier on June 5, 2013 at 12:42 pm

      “If demand falls short by 2%, then price falls by 20%. Conversely, if demand rises 4%, then price rises 40%.”

      I have had to explain this to people who can’t understand how a small change in the supply/demand picture can have such a large impact on price. One person insisted that a 5% increase in demand should increase price by 5%.

      Do you have a source for the above quote? That would come in handy.

      • By TDarden on June 5, 2013 at 1:52 pm

        The quote is attributed to Dr. James Smith of SMU’s Cox School of Business. It looks like Jennifer included it in one of her posts on the website for the Dallas Committee on Foreign Relations.

      • By Jennifer Warren on June 5, 2013 at 4:44 pm

        Robert, the original paper is called, “World Oil: Market or Mayhem?” See page 155-6, Short-term Inelasticities of S/D, for the real hard core equations. The summarized version is:

      • By armchair261 on June 7, 2013 at 2:37 am

        A good thought experiment to bring this point home goes like this.

        Imagine an island with 100 diabetics. They all pay $100.00 for their monthly supply of insulin. But, due to supply problems, the island will now only receive enough insulin for 99 people. Supply has dropped 1%. People who insist on linear supply-demand-price relationships must also insist that there is a diabetic on that island who will refuse to pay more than 1% extra for his medicine, and therefore the price will stabilize at $101.00.

  4. By ben on June 5, 2013 at 2:14 pm

    I like this piece, too. RR’s analysis is typically well-grounded. Concerns exist, however, about demand destruction and that plays into perspectives on trends in energy prices– something that is not entirely unfavorable, as it may help salvage at least modest levels of growth. The deleveraging of the past half-decade continues to run its ugly course. We are probably about halfway through a portfolio rebalancing even as we wrestle with a generational transition toward more diverse energy supplies; this occurs against a backdrop of eroding US hegemony (read: dollar domination) within the international financial order. Since the very outset of his blogging, RR has sounded a realistic note on the timing and tempo of this transition and its implications for American commerce and households. Muddling toward an inconvenient truth (called reality) is one way to put it.

    There has, of late, been an academic argument raging about the proper assumptions upon which to base realistic projections of future economic growth. Unsurprisingly, these debates have not always reflected a level of objectivity that we might expect, or at least hope for, from practitioners of the “dismal science.” A point of particular contention has been the role that public debt as a percentage of GDP has on economic output. Regrettably, there are those who have embraced a partisan orientation to their own analysis while going out of their way to impugn the professional objectivity of others who have presented research for others, to include those wily politicians, to assess.

    Given the knee-jerk reaction among various “stimulators” there is plenty of evidence the specter of austerity may pose as much of a political threat as a long-run economic performance burden. I might note here that ETI’s own contributing economist, James Hamilton, very much to his professional credit weighed in on this important issue
    (See: Reinhart & Rogoff Controversy resulting from authorship of “Growth in a Time of Debt” and “This Time is Different: Eight Centuries of Financial Folly.”) I commend Dr. Hamilton for not only his objectivity but a measure of valor in stepping up to defend fellow academics who deserve little of the Leviathan’s bluster with its pretensions of setting the record straight. There has been precious little objectivity coming out of pump-primers for a generation. All of this must, and will, change. The steady erosion of a post-Bretton Woods financial order will only serve to reconfirm the primacy of fiscal sensibilities. Too bad there are those who deny reality and in so doing they join a cadre of climate change Luddites tilting at imaginary windmills.

    Yes, energy prices will likely remain in a fairly stable range for several years. The disappointed news is the lack of progress we are making in developing strategies to
    position our economy for the challenges ahead. One things for sure, the Tigers continue to sharpen their claws. We have an African saying: sharpen you knife before the tigers come to dinner:)


  5. By richtfan on June 6, 2013 at 9:08 am

    this is just more proof that we need to develop US natural gas supplies for everyday auto and truck fuel. you wanna see OPEC fall apart, just get that going in a big way. you’ll see oil back around $20/barrel in no time.

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