Given the roller-coaster ride of the last 14 months, budgeting for that next big CAPEX project can’t be easy. When the project comes onstream, will oil be selling at US $300/bbl? Or $3/bbl?
Predictions are all over the map on this one. But James Smith, who holds the Maguire Chair in Oil and Gas Management at Southern Methodist University’s Cox School of Business, has done some research indicating that price spikes in the summer of 2008 will not necessarily be repeated any time soon. His research, “World Oil: Market or Mayhem?” was published in the August 2009 Journal of Economic Perspectives.
I talked to Smith about what led to the research and what some of his more interesting findings were.
Smith has studied the world oil market since 1973 and said the price spike in 2008 caused him to examine market dynamics in more detail. “If you look at economic fundamentals like supply and demand and ask if the world oil market operates like other markets, I find that it very much does,” he said.
Overall, he said, doing the research offered up few surprises. However, the growth in demand – 33% from 2004 to 2008 – was greater than he’d expected. “Everyone has been talking about China, India, and other developing economies, but no one had really parsed out what portion of that was due to the actual shift in the demand curve, the increase in their willingness to pay for a given amount of oil,” he said. “That’s one of the things I was able to calculate in the article, and it really was an unprecedented stretch of growth.”
Overall, his findings are in line with others who are concerned about increased government meddling in the market. The new ruling by the CFTC, for instance, to more closely monitor energy trading and hedging, will have the effect of reducing the liquidity of the market, the efficiency with which people can hedge risks. “This will ultimately expose commercial producers and processors of energy to more risk, and it’s costlier for them to manage that risk. And it’s all for no reason, because I don’t see any economic basis either in theory or in practice for the claim that speculators and hedge fund money or commodity index funds had any impact at all on the spot price of oil or on the futures price.”
As for some countries considering price regulation, he commented, “I hope we’ve learned our lesson that that’s a really dumb thing to do. It only generates shortages and puts further cost and burden on consumers.
“Fortunately, we’re further along economic development and have learned some of these lessons, albeit the hard way. The Chinese are still learning them. For the last two years they’ve had shortages of electric power and of their liquid fuels because they regulate the prices. And as much as they want to emulate a market economy, they’re still convinced that they can somehow administer the prices and it will all work out in the end. They’re learning the hard way the things that we already should know.”
A summary of the report, written by Jennifer Warren, follows:
Oil market is no mystery: Look to fundamentals
In summer and spring of 2008, Goldman Sachs analysts, Boone Pickens, and other prognosticators said oil prices would rise to $200 or more a barrel, and forecasts for $300 oil still linger. These voices, some with self-serving motives, hold little sway on the real price of oil, current or future. Unlike the stock market, which moves according to incident, expectations, confidence, and manias, oil markets move on the fundamentals of the real asset, something more tangible and elemental.
Smith shows in his research that the oil price spikes of summer 2008 will not necessarily be the trend in the future. Based on supply and demand factors, an analysis of which is missing in many of the high-end forecasts, Smith reveals the causes behind the much-debated high trajectory of oil prices and how the cartel OPEC had a lot to do with it.
From their "breathtaking ascent that reached $147 per barrel by July 2008," oil prices then dipped below $40 per barrel again before the end of 2008. Previously, oil prices were stabilized around $30 during 2000-2004. As of this writing, oil has hovered in the neighborhood of $70 per barrel. Government leaders concerned with future spikes, particularly in France and the UK, have suggested regulating oil markets in their respective countries. Smith says that such types of regulation typically create shortages. The US had that experience in the late 1970s and early 1980s when it tried its hand at price regulation.
Smith writes that a unique combination of economic circumstances surrounds oil markets. A short list would include:
- extremely high price volatility;
- the prominent role and unusual longevity of a major cartel (OPEC);
- the size and scope of the oil industry and its links to economic growth;
- doubts of oil's sustainability;
- its CO2 emissions that pulls oil into the center of the climate change debate; plus
- a host of geopolitical issues that reflect the uneven distribution of oil deposits around the globe.
Of the short list and its relation to the highs experienced last summer, OPEC ranks at the top of the contributors’ list, alongside a series of supply shocks in the run-up to July 2008. Smith says, "OPEC ran out of capacity and couldn't accommodate the unexpected surge in demand, which occurred from 2004 onward. The capacity issue goes back several years; if OPEC [members] had made investments to build up capacity, they would have intervened before July 2008 to keep prices below $100 a barrel." He continues, "They did start upstream investment in 2004, adopting a five-year plan, but it was not soon enough. Today, they are cutting back on quite a few individual projects, though a number are moving forward. "
Global demand for crude oil has increased by 80% overall since 1975, whereas actual OPEC production and non-OPEC supply have each grown by just 24%. During the 1980s, while global demand for oil was shrinking, the supply of non-OPEC oil was expanding robustly, putting substantial downward pressure on price, and OPEC producers responded by cutting output nearly in half between 1979 and 1985. After the steep decline of the 1980s, OPEC production was not fully restored until 2004.
"OPEC's production restraint represents a commercial choice, not a geological ultimatum or a reflection of high marginal costs," Smith says.
For 30 years, until roughly 2003, non-OPEC producers were able to offset depletion of known reserves via exploration and technological innovation, and they managed to increase supply in concert with demand. Also, part of the decrease in supply that occurred after 2003 was the result of rapidly escalating costs in production (like cost of pipe and drilling rigs) rather than resource depletion. Over the long haul, demand has outrun non-OPEC supply.
From the period 2004 to 2008, global demand increased by 33%, while non-OPEC supply decreased by 23%. Although OPEC members responded by increasing their production, they lacked sufficient capacity (after years of restrained oilfield investments) to bridge the growing gap between global demand and non-OPEC supply. Prior research by Smith revealed that OPEC's goal is to set the price, and members synchronize production levels in pursuit of that goal.
Consumers have suffered from OPEC's failure as well as its success: failure to manage installed capacity has increased price volatility, while success in restricting capacity growth has driven up the average price level. OPEC's production capacity -- 34 MMb/d -- is virtually unchanged from 1973; the volume of its proved reserves doubled over that span. In comparison, non-OPEC producers have expanded their production capacity by 69% since 1973.
OPEC accounted for only 10% of the petroleum industry's upstream capital investment during the past decade, although it produced nearly half of global output. By holding back, OPEC has effectively allowed secular growth in demand to absorb and eliminate its excess capacity, ceding market share to non-OPEC producers in the process.
OPEC recently initiated numerous projects to tap its underdeveloped reserves and finally expand capacity, investments that would amount to some $40 billion per year between 2008 and 2012. The five largest international oil companies, which own just 3% of global oil reserves, spent about $75 billion during 2007 to develop new production. OPEC, with 20 times the reserves, spent about half as much.
According to Smith's calculations, not until the price surpassed $50 per barrel around 2004 did OPEC finally begin to create incremental capacity. Below the $50 mark, most OPEC members have little incentive to relieve supply pressures.
Price spikes, shocks, and speculators
The year 2008 witnessed large price swings, but volatility in oil prices is par for the course. The annual volatility of crude oil prices is high: 31% when calculated over the "modern" era (1974-2007), whereas annual volatility averaged only 20% during the "golden age" of oil from 1874-1973. These annual volatilities are quite high because the underlying demand and supply curves are so inelastic. Demand is inelastic due to long lead times for altering the stock of fuel-consuming equipment; supply is inelastic in the short run because it takes time to expand the productive capacity of oil fields. This fact means that shocks to demand or to supply can help to explain the high level of volatility in oil prices.
Thus, some combination of demand growth from the likes of China, India, and others, with a reduction to oil supply from higher production costs, can partly explain a substantial rise in oil prices after about 2004. If oil prices had not risen past $90-$100/barrel, as in January 2008, these explanations might have sufficed. However, prices rose 50% more between January and July 2008. Smith says by early 2008, China's growth and higher supply costs should have been priced-in. So what happened?
Smith points to short-run issues. Seemingly small shocks exert large effects in oil markets. Taking 1 million barrels per day out of the world market is a loss equal to roughly 1.25% of total 2008 output, creating excess demand of 1.25%. When demand and supply are both highly inelastic, they combine to create a large multiplier effect -- each physical shock should trigger a short-run price adjustment about 10 times as large.
When asked about whether reduced consumption in the developed world can offset the growing demand from the developing world, Smith replied, "We can't conserve enough to offset the growth in demand from China, India, and others. They are too large and their growth rates too fast; conservation cannot hold world demand in place -- world demand will grow." He concluded, "It will take innovative investments in supply and higher prices to keep the balance. Prices will inch up. They have doubled since I wrote this paper. They could even shoot up if there's an outage." In the short run, $147 a barrel is not incomprehensible, Smith calculates, but not really in the long run.
Shocks to supply in the spring of 2008 had much to do with the dramatic spike in oil prices. The disruptions were many: the Venezuela-Exxon battle in February; multiple problems for Iraqi exports; multiple disruptions in Nigeria that impacted supply; labor strikes in the UK; and the rapid decline of Mexico's Cantarell oil field. In quick succession, these events contributed substantially to the rapid price rise of oil. So, surging demand and falling supply reveal the most likely source of the rise, not the traders or speculators targeted by regulators. According to Smith's analysis, "The distinction between hedging and speculative trading in the futures market is not important because neither one exerts any significant effect on current oil prices."
OPEC does engage in price fixing, and oil prices would not have reached $147 per barrel if OPEC had not previously restricted investment in new capacity. OPEC aside, there is no evidence of price fixing on the part of anyone else, which includes both speculators and the super majors. "Relative to the size of the world oil market, hedge funds and even the super-major oil companies are small fry," Smith states.
Here and now
During the second half of 2008, the collapse in demand for oil around the world was due to economic decline. Despite global consumption (and consequent depletion) of almost 700 billion barrels of crude oil during the past quarter-century, the stock of remaining proved reserves has doubled from 700 billion barrels in 1980 to an all-time high of 1,400 billion barrels. "Consider the impact of horizontal drilling in oil and gas,” Smith explains. "Huge resources that were previously uneconomic can now be developed because of that technological advance, an example being the Williston basin, the largest undeveloped oil resource in the US." He adds that advances in the processing of seismic data beneath the ocean floor revealed large oil deposits in the Gulf Of Mexico and Brazil, previously hidden beneath layers of salt. "We peeled back another layer that we previously didn't know how to penetrate. New technology can have a big impact on the resource base and price."
Smith acknowledges that we cannot prevent the supply of conventional oil from ever declining. But in the longer term, he believes ample supplies of unconventional petroleum resources and other substitutes for crude oil should prevent oil prices from surpassing the mid-2008 peak on any sustained basis. Regarding the high-end forecasts tossed about by various analysts and executives, Smith questions, "Where's the global economic expansion coming from to sustain consumption at those high prices? Look at the demand curve. There's a big focus on supply and the depletion story, but demand is sensitive to price."
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