Oil market slides out of control

For most of the Age of Oil, groups of producers have tried to control its price. From the 1920s, that strategy was co-ordinated by the Railroad Commission of Texas, supported by other US states and federal authorities. Then from the 1970s it was Opec, the producing countries’ cartel.

The plunge in the price of crude since the summer of 2014 has made it clear that the market has escaped anyone’s ability to control it.

For now, at least, prices are being driven more by market forces than by political decisions and it is an unnerving experience for everyone concerned, from the boardrooms of Houston to the palaces of Riyadh. It is not, however, wholly unprecedented.

In the words that are apocryphally attributed to Mark Twain, “history does not repeat itself, but it does rhyme”. So, while there are no exact precedents for today’s markets, the past can provide some clues to the future.

The most recent oil price collapse came just seven years ago. The downfall of Lehman Brothers in 2008 and the subsequent financial crisis toppled crude prices from a higher peak than in 2014 to its lowest trough. That episode turned out to be shortlived. Having dropped below $37 per barrel in December 2008, internationally traded benchmark Brent crude was back above $70 by June 2009.

On the demand side, 2015 looks quite like 2009. Six years ago, the swift resumption of strong growth in China, after a brief wobble in late 2008 and early 2009, provided important support to prices. This year, similarly, growth in China’s oil demand has been strong, though forecasters expect it to slow. It is the supply side that is different.

In 2008, there was decisive action by Opec, which cut its agreed output by 4.2m barrels per day in three steps from September to December, culminating in the largest single reduction in its history that helped stabilise prices.

The cartel’s ability to control oil markets is often exaggerated, but it is clear that its intervention in 2008 had a very significant impact. When its ministers met in Vienna on November 27 last year, as the latest price slide was in full swing, they suggested their influence had reached its limits.

Their decision to leave their official production level unchanged set the seal on a policy that had already been signalled for months by Saudi Arabia, the group’s most influential member. As Ali al-Naimi, Saudi Arabia’s oil minister, explained later in an interview with the Middle East Economic Survey, a cut in Opec production, meaning principally Saudi production, would have merely allowed more “marginal barrels” from US shale and other higher-cost sources to fill the gap.

The clearest precedent for Mr Naimi’s strategy of turning on the taps is the policy adopted by Sheikh Ahmed Zaki Yamani, his famous predecessor, who boosted production in 1985-86 after cutting back over the previous half-decade to support prices. Crude plunged in 1986 and the world entered a period of low prices that stretched into the 2000s.

Another parallel with today was the preceding surge in non-Opec production. The equivalent of this decade’s shale boom was the opening of two important new oil provinces: the North Sea and Alaska.

The development of those areas, which were relatively high-cost compared to oilfields in the Middle East, was made possible by Opec moves that forced up the price of oil in the 1970s, just as shale was made viable by the high prices of the first half of the 2010s.

Although low prices hit investment, prompting cost-cutting from western oil companies including the mega-merger wave at the end of the 1990s, production took a long time to respond. The UK, Norway and Alaska continued to produce in large volumes through the turn of the century.

Eventually, though, as those regions went into decline, and demand from China and other emerging economies began to grow strongly, the stage was set for the steep rise in prices of the 2000s. The question today is how quickly a similar adjustment of supply will materialise. At the beginning of this year, many expected that the US shale industry would head quickly into a downturn.

So far, it has not turned out like that. Production companies have been able to squeeze out further efficiency gains and cut the prices they pay suppliers. They have also been “high-grading” their operations: focusing on the most productive areas. US production has proved more resilient than some had expected.

However Trisha Curtis, of the Washington-based Energy Policy Research Foundation, says oil at under $50 is causing “quite serious” problems for the industry. Blithe assertions that everything seems fine ignore the fact that there is always a lag before production reflects the number of rigs drilling for oil, which has dropped 63 per cent in the past year. “It’s going to take a while,” says Ms Curtis. The shale industry is not dying, she adds, but it may be going “into hibernation”.

In other oil-producing regions, where project developments are typically multiyear and multibillion-dollar commitments, production will be slower to react to the fall in price of crude.

Philip Verleger, an energy economist, suggests Venezuela, a leading oil producer now in the grip of a severe financial crisis, could crack first, with mounting chaos in the country putting its entire 2.4m b/d of production at risk.

For those reasons, while the oil market will for a while be weighed down by near-term pressures, including the prospect of additional Iranian supply, the longer-term price trend still seems likely to be upwards, with the potential for spikes if crises erupt in Venezuela or elsewhere. Edward Morse, analyst at Citigroup, suggests a range of $60-$80 per barrel would bring supply and demand back into balance.

The idea that supplies of fossil fuels will grow ever tighter as demand increases, pushing prices inexorably higher, has been put on ice, perhaps forever. The lesson of the past decade is that so long as the right technology, capital and legal frameworks are in place, oil and gas will flow. If the world is to shift away from fossil fuels, therefore, governments will need to take deliberate policy actions to make that happen.