Oil Prices – what’s going on?

The oil industry went into a panic when prices dropped to a 13-year low of $26.02 per barrel in February 2016 (from $107 in July 2014). But, as the chart below shows, oil prices have been volatile for some time.

oil prices chart

In fact, from 1970 until 2003, oil averaged $25 per barrel. Then in 2004, prices suddenly doubled and then more than doubled again – reaching a record high of $141 in June of 2008.  These increases were due to a series of global events: a significant increase in global oil consumption among developing nations and a reduction in supply due to – Hurricane Katrina in the Gulf of Mexico (2005); reduced production by Iran due to their geo-political issues; and the war in Iraq. Then in late 2008 the global financial crisis severely reduced demand and oil fell dramatically only to recover to $100+ within 12 months.

But, since August 2014 oil prices have been on a steady decline. The reasons are many:

  • Oil consumption (demand) did not increase to anticipated  levels, particularly in China and Europe.
  • North American production increased by 70% from 2008-2015. Hydraulic fracking of shale oil was a major factor.
  • Other forms of energy (wind, solar) were beginning to become main-stream options.
  • Despite lower demand, increased supply and lower prices, OPEC refused to cut back their production – something they had done consistently in the past to manage prices.

So, a lower demand with increased supply meant that prices had to drop until existing inventories were reduced, high-cost oil production operations (shale) shut down thereby no longer adding to the supply and low-cost production countries (OPEC) started considering production cut-backs. In other words, the market would correct itself when cost of production was much higher than the price. By March 2016 that became the reality and many high-cost producers shut down thereby reducing the new supply of oil. As a result prices recovered to $50 by June 2016.

Nobody really knows what oil prices will be in the future but some experts believe that we should prepare for oil to hover around $50 per barrel for the foreseeable future. Here’s why this makes sense:

  • In January 2016, the USA lifted the 40-year ban on exporting US oil thereby increasing the global supply
  • Shale oil production can come back on-stream quickly as inventories are depleted
  • China and Argentina are now developing their own shale oil production capabilities
  • To compete with shale drillers, conventional oil players are improving their field productivity by focusing their resources on more easily recoverable reserves (thereby lowering their production costs).
  • The rise of electric cars, which do not burn gasoline, could negate the historical 1% organic growth rate in oil demand.
  • Even if OPEC countries decide to reduce production to manage prices, the US and other shale-oil producing countries will increase production to fill the gap.

The bottom line is that we now have more global supply options than ever before.

$50 oil puts some producing countries under considerable stress as they grapple with less oil revenue in their national budgets. Venezuela, Nigeria, Iraq, Iran, and Russia could be forced to address substantial budget deficits within the next five years.   Gulf Council producers such as Saudi Arabia, the United Arab Emirates, Kuwait, and Qatar have amassed considerable wealth during the past decade through cash reserves and sovereign wealth funds, but even these countries could come under stress in the next decade because they have committed to significant infrastructure and social spending programs that are heavily dependent on their oil revenues.

But $50 oil also has some major advantages:

  • Consumers are paying a lot less for a gallon of gasoline thereby increasing their overall spending power
  • Industries which are heavily dependent on oil – airlines, trucking and farming – are also benefiting from reduced costs
  • Countries which must import oil (India, European nations) are saving tens of billions annually and can deploy this cash to other deserving projects.

For decades we debated when the world would eventually run out of oil. That is no longer the question. Instead, the issue now become who will control oil’s future and how and when will the world transition away from it. The impact of this disruptive force on the earnings of companies that produce oil, and those that consume it, is likely to be substantial and sustained.