Regular reader Chris commented about yesterday’s post that we may be in the early stages of a decade+ downcycle in the oil price. I thought I’d elaborate on that thought today.
base metals–gold, too
I think the situation with base metals is very clear. Capacity is typically added in very large increments, and by all parties in the industry at once, creating the top of the market. The mines can be shut down, but the orebodies don’t disappear. Neither does the machinery. So operations can be restarted fairly easily. As a result, the market only comes back into balance as economic growth slowly expands, eating into the oversupply overhang. Last time around, in the early 1980s, this process took well over a decade.
Th case of oil is slightly different. The petroleum industry is far bigger and more important than metals. In most cases, there are no good substitutes. Use for heating and transportation can’t be postponed.
Discovery of new reserves is a much more important factor in production. The ability of oilfields to extract output without significant new drilling can deteriorate sharply if wells are shut down, interrupting the underground flow of oil to them. Because of this second factor, very small differences between supply and demand can have dramatic.
At the last oil peak in 1980-81, two factors conspired to stretch out in time the fall in prices needed to restore supply-demand balance.
–The US, the world’s largest petroleum consumer, enacted a byzantine series of price control laws to prevent higher oil prices from being passed on to consumers. This delayed conservation into the 1980s, when the regulations were dismantled.
–Saudi Arabia, then the largest oil producer in the world, decided to cut its production in an unsuccessful attempt to prop up prices. It went from 10+ million barrels per day in 1980 to just over 3 million in 1985. Although other OPEC members also agreed to curtail production, widespread cheating (typical cartel behavior) undermined the supply reduction effort. The oil market finally bottomed at around $8 a barrel (the high was $34 in December 1980) when the Saudis got fed up and began to restore production in 1986.
This time, neither factor is present. The only residual of 1970s efforts to promote oil use in the US is the country’s relatively low level of tax, by world standards, on gasoline. Saudi Arabia, having learned a bitter lesson from the 1980s, has actually increased production slightly.
I think this means that the bottom for oil will come much more quickly than in the 1980s. It may be happening now.
I don’t think there will be a quick rebound, however, even though the excess supply now present in the world may only amount to 2% – 3% of total demand. That’s because:
–demand is growing more slowly than experts have been predicting
–hydraulic fracturing is proving less vulnerable to lower prices, as frackers streamline their procedures to lower costs (no one worried about efficiency when oil was $100 a barrel)
–removal of economic sanctions on Iran will give a one-time boost to supply of about 500,000 barrels a day (on world production of roughly 90 million bbl/’day).
If I had to guess, I’d say that fracking has permanently changed the supply/demand situation in oil. New capacity can be added quickly, in lots of small increments, at around $60 a barrel. I think this puts a (permanent?) ceiling on the oil price, or at least one that lasts for longer than we as investors need to worry about.
The bottom is harder to figure out. If we were back in 1980, when world demand was about 60 million barrels a day and almost half came from ultra-low-cost sources in OPEC, revisiting the 1986 lows might be an ugly but realistic option. However, with production now around 90 million and the Middle East closer to an afterthought than a real price-setting power, enough output is being curtailed at current prices that I think we’re probably in the bottoming process now.
At some point, aggressive investors will sift through left-for-dead small exploration companies to find survivors. I’m sure industry experts are already doing so. I’m not an expert any more. I’m not doing so yet. My inclination is to look for consumer or tech companies that stand to benefit from the boost to economic activity created by lower oil.
I’ve been mulling over the past week that the Saudi (and to some degree OPEC) were less about controlling shale and more a preparation for the return of Iranian oil to the world market.
It might be more like 1 mbd rather than 500K. And attractive for both Europe and China.
US oil production had slowed a bit finally — down 100K b/d from last year after a brief rise earlier this year.
All way above my pay grade. I’ve done nicely on refineries this year but I suspect we have a gasoline glut in both the US (and a diesel glut in china).
In terms of consumer behavior, I wish I knew. The refineries are reporting high margins on premium, and I see 60-70 cents in the DC area (should be 20-30). Localized high prices in California are having effects as well.