The oil industry is going through its third crash in prices since the formation of the OPEC cartel. Many are wondering when the market will recover and what oil prices will be when it finally does.
The first price crash came in the mid-1980’s, a decade after OPEC’s formation. The second crash came at the onset of the Great Recession in 2008 when oil prices fell from over $100 a barrel to below $40. The third one is the present decline, which began around September 2014. What do the first two experiences tell us about how the present price collapse will play out?
Oil prices affect oil consumption slowly, and they affect oil production in non-OPEC countries very slowly. The OPEC cartel tries to maintain price targets by varying its own production in respo960nse to imbalances in the world oil market. This requires cooperation among its members and is far easier to do when the market pressure is pushing prices up than when it is pushing prices down. Maintaining prices is especially hard if the downward pressures are expected to be longer lasting rather than transitory.
The mid-1980s price decline proved to be long-lasting. When the major Mideast oil producers formed the OPEC cartel decades ago, they quadrupled the oil prices from $3 a barrel to $12 by producing a little less oil. Prices rose further in 1979 when the Shah of Iran was overthrown. The huge jumps in oil prices were a boon to oil producers. But they also brought about strong market responses that eventually pushed oil prices down. Non-OPEC production rose as a result of the creation of huge new fields in Alaska, the North Sea and elsewhere. Fuel efficiency became a key selling point in the aircraft and car markets. Oil prices collapsed when OPEC could not agree on output reductions to offset these changes in the global market. More importantly, these changes proved to be lasting, so that from the mid-1980s until 2000, prices rose only gradually from their 1986 lows.
The price collapse of 2008 happened differently and ended differently. By the turn of the century, changes in both the supply and demand side of the oil market started pushing up oil prices. New non-OPEC supplies were proving harder to find, war interrupted some Middle East production, and fuel demand from China expanded rapidly. By the summer of 2008, oil prices rose rapidly had gone above $100. And then the onset of the Great Recession crashed them to below $40. But this sharp drop in demand was transient: China’s fuel needs continued to surge and recovery started in the advanced economies, reviving their fuel demands. Production from the new shale oil industry added to global oil supply, but not enough to keep prices from rising. By 2012, the world oil price was back to over $100, and it stayed there until the present price collapse.
As this survey suggests, the key to today’s oil market is whether the forces that caused the price collapse in the past 15 months were temporary, like those in 2008, or long-lasting, like those in 1986. China’s growth has slowed, and that will be long lasting but may not be a big enough shift to dominate the oil outlook. The growth of the shale industry is much more important. Shale oil production will respond to the price of oil with only a modest lag—a key difference compared to the very slow response of conventional oil fields, and one that cuts both ways. It means supply will be curtailed more quickly in response to low prices. And it also means production will rise more quickly as prices recover.
The recent decline in shale production would suggest we are near a bottom in prices. But a couple of other factors will probably keep prices depressed longer. First, now that the embargo on Iranian exports has been lifted, Iran will be adding 0.5 million barrels per day to its output, and the other OPEC countries have refused to cut their production to accommodate that. Furthermore, oil inventories have been rising for several quarters and are at record levels. Reducing this overhang and absorbing the added production from Iran will both delay a return to normal production trends. The recovery, which might otherwise have started this winter, will probably be delayed until late next year.
When the market does return to trend, shale oil will be the marginal source of new oil and the price will depend on the evolving technology of this new industry. Shale output was soaring with prices at $100, and this rising supply, more than any other single development, is what caused the oil prices to plunge. When oil is back on its long-term price trend, the price is likely to be between $100, which brought forth too much oil, and $40, which in recent quarters was low enough to stop new drilling in some fields. A price near the middle of this range, $70, is a reasonable forecast at this distance.
Source: Fortune
