Oil at 2015’s close

December 30, 2015

Our world runs on oil. It’s not used just for gas. Rubbers, plastics, lacquers, waxes, inks, fabrics, glues, solvents, insecticides; pretty much everything you touch is a few degrees of separation from oil.

Oil is a relatively finite resource. Sure, you can whip some up in a lab over the course of a day, but only if you don’t care about expending ‘more’ energy than the oil gives back. The ‘free’ version happening below our feet takes millions of years. It takes time for the Earth to move the required materials into the appropriate conditions.

So oil’s a requirement of modern civilization. It’s finite. But why is its price so erratic? Why is something with unlimited application and limited worthwhile supply priced today at a third it was two years ago?

Price bar chart
Monthly West Texas Intermediate oil price, 1996 through 2015

I’m no oilman, but here’s my understanding:

Emerging markets like China contributed to increased oil demand starting in the 2000s, but China only doubled its oil consumption from five to ten million barrels per day. The United States remained the largest oil consumer at twenty million barrels, and Japan slipped from second to third by holding steady with their five million.

Global consumption changed by five million barrels per day between 2003 and 2008, which doesn’t alone account for the over four-hundred percent increase in price during that same time. And when oil went from $148.74 to $32.69 in six months, neither global production nor consumption expressed any appreciable change.

In 2004, the Organization of the Petroleum Exporting Countries (“OPEC”) agreed to lower maximum production by five percent, resulting in an increase in demand. Once oil’s price was higher and more attractive as a result, OPEC then increased production to take advantage of it.

OPEC is a big reason for oil’s price. OPEC members produce 75% of the world’s oil. They own so much of the production because its so cheap for them to produce it. Cheaper production means higher profits when sold abroad, particularly to oil-reliant nations where local production is expensive due to limited remaining oil resources, harder required extraction methods, and laws.

Later in the second half of 2004, Hurricane Ivan caused substantial damage to oil infrastructure along the gulf coast of the United States, where a large amount of American oil infrastructure lies. The next year, Hurricane Katrina and other storms further degraded the region’s infrastructure.

Hurricane path
Hurricane Katrina’s path through the gulf coast’s oil industry

During the same time, militias in Iraq and Nigeria mounted continued attacks against local oil facilities, reducing their enemy’s revenues and the world’s oil production capabilities.

Seeing an already reduced global output, OPEC decided that instead of increasing production to satisfy demand, they would once again reduce production to bleed their buyer’s stockpiles and increase margins. The world needs oil. Price doesn’t matter.

To complicate things, oil is traded on futures markets like all commodities. Futures are contracts, obligating purchase at a set price. Contracts keep producers from going out of business during market volatility and help sellers finance debt to fulfill contracts, since sellers know how much they’ll make.

Like all markets, speculation is rampant. Take the stock market: It moves up and down, but most movement is speculative nonsense and noise. Isaac Newton allegedly said of the South Sea Company’s stock price, “I can calculate the movement of the stars but not the madness of men.”

The story is Newton identified the speculative madness surrounding the company and sold his over-valued shares for a profit. Then greed got to the best of him, and he bought back in at an even higher price, just before the pop. As the saying goes: Pigs get slaughtered.

South Sea Company’s stock price

So with futures contracts in mind, pretend you’re OPEC. First, reduce your oil production to increase demand, thereby causing a price-bidding war. Second, consider perhaps taking part in that price-bidding war, for no other reason than to increase prices.

But high oil prices are for everyone, OPEC and non-OPEC alike. They also mean ‘unconventional’ techniques, like fracking, are profitable. Oil’s high price in the mid-2000s meant it was time to start or expand an oil company.

Concurrently, the housing and financial crises happen, weakening the American economy. A weak economy means lower tax revenues, and since the dollar is insured by the government’s ability to collect taxes, the dollar’s worth relative to commodities and foreign currencies diminishes. Some of oil’s high price was due to the dollar’s lowered worth.

Many banks also speculated on oil’s rising price, but needed to sell their positions to pay down debts during the financial crisis.

In a bid to lubricate America’s stalling economy, President Bush lifts the ban on offshore drilling. The result was a speculative sell-off in oil and buy-in of oil companies.

Renewed confidence in the American economy caused an increase in the dollar’s foreign exchange rate, causing oil to decrease further in price while still retaining the same value. This confidence would then occasionally falter during recovery, causing oil price volatility.

By 2012, new conventional and unconventional oil wells were up and running, pumping more oil out each day than was consumed. At the same time, cold winters, economic troubles, and political instability in Europe, as well as demand for oil in emerging markets, caused multi-year deviations in price between West Texas Intermediate (American, lower price) and Brent (European, higher price).

Price bar chart
Price deviation between West Texas Intermediate (bars) and Brent (line)

OPEC again convened. Their price-setting made competitors profitable. There was too much oil in the world, more than anyone could use.

But OPEC decided not to cut production. Instead, they would keep production up and slowly edge competitors back out of the market based on price. It was a war for market share. Venezuela, Saudia Arabia, and other OPEC nations each individually have anywhere between decades and hundreds of years of oil reserves at current production rates while their competitors do not.

The only non-OPEC nation with similar reserves is Canada, but it costs $46 to break even on the production of Canada’s cheapest barrel. That’s well above Saudi Arabia’s cheapest at $10.

Oil production cost curve

But OPEC can’t simply edge others out on price. Their competition can’t just turn off pumps and wait for a better price like they used to. They took on debt to open new wells, and that debt must be repaid. No one could fathom cheap oil at the time. They see it better to be unprofitable than bankrupt.

And so the world produces more oil than it consumes, abundance further lowering oil’s price. OPEC still profits. Non-OPEC runs at a loss while drying what little’s left in their wells.

Daily average of oil overproduction by year
628 million unwanted barrels produced in 2015, on top of 2014’s 303 million surplus

The effect of oil’s price is far reaching. Inexpensive energy is good for economies. Many industries have lower operation costs, making them more profitable. But other industries, like energy itself, are made less and less profitable the more inexpensive energy gets.

That affects renewables too. Fewer people will justify the expense of solar, wind, hydro, or whatever else when oil is inexpensive.

On December 4, 2015, OPEC members met one final time for the year. As there was too much out oil in the market, with a barrel costing just $40, Saudi Arabia’s profit margin had fallen from five hundred percent per barrel to just sixty percent. But that’s just the barrel itself. For the Saudi Arabian economy as a whole to run above deficit, they require a higher oil price.

Since non-OPEC can’t stop production without bankruptcy, OPEC can’t easily create an artificial scarcity to inflate profit margins. OPEC again committed to maintaining production to further bleed competitors.

And it’s working. Standard & Poor’s rates the American economy at its most distressed since the financial crisis. It’s a bad time to be an energy company, especially an oil company. Your operations are unprofitable, unhaltable, and no one’s willing to buy your wells when they can pick them up for even less at your bankruptcy liquidation.

It’s also a bad time to be Canada, Venezuela, Russia, Iran, Saudi Arabia, Daesh, Boko Haram, or anyone else substantially reliant on oil revenues.

I’m of the opinion that what we have today is truer to oil’s actual price than what it has been these past few years. Oil’s price was artificially inflated.

However, I also believe once OPEC disciplines the rest of the market enough, they’ll return to manufacturing scarcity to increase margins. Their economies require high oil prices too.