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Is This The Next Oil Price Collapse?


While OPEC and its compatriots struggle to cope with the demand weakness caused by the covid19 virus, it must be asked if this is more than a brief interlude in an otherwise robust oil market (robust in terms of price, not demand). The sharp decline in world equity markets is certainly alarming and raises the issue, mentioned in an earlier column, that a recession is being triggered.

The soaring stock market of recent years does suggest that there is perhaps a financial bubble which is now being burst. The U.S. economy appears strong to the point of being overheated and the stock market has been supported in part by increasing debt, in this case, the U.S. federal deficit being used to stimulate the economy.

It reminds me of 1998, when I was in a bar in Australia reading Panics, Manias and Crashes by M.I.T. economist Charles Kindleberger (yes, I’m dashingly romantic), with a cover blurb by one of his associates saying in effect you will someday soon find this book relevant. Given the gathering Asian financial crisis, I had to laugh. This time around, I find myself reading Bubble in the Sun by Christopher Knowlton, about the 1920s real estate boom and bust in Florida. That was a bubble punctured in part by a massive hurricane which destroyed significant amounts of property.

Could the covid19 virus be a trigger to a new recession, a new oil price collapse, or both? The first and most important point is that oil prices were not ‘low’ before covid19 but somewhat higher than the historical norm as the figure below shows. Prices have been well above the historical mean since roughly 2004, even after the 2014 price drop. The industry, and many observers, suffer from the ‘high prices are the norm’ belief just as farmers do about agricultural prices; few acknowledged, when oil prices were above $100 per barrel, that they were elevated by transient supply disruptions, instead insisting that ‘the easy oil is gone.’

On the other hand, prices were clearly much closer to the historical norm than in 1985 or 2014, two of the three major price collapses in modern history. (Modern history meaning during my career.) Instead, the situation is somewhat reminiscent of 1998 when oil prices were already low and dropped by about one-third, in part due to economic weakness but also a price war between Saudi Arabia and Venezuela. This time, the combination of covid19 and the tussle between Saudi Arabia and Russia has created the incredible price drop (as of 7 a.m. EDT). This implies that, after a period of chest-thumping, a new agreement will be reached and prices will largely recover.

On yet another hand, the reality is that the market has been oversupplied by a combination of rising shale production and increased conventional supply, from Brazil, Guyana and Norway, despite the near-total loss of Iranian and Venezuelan supply. This implies that the market situation resembled 2014 in terms not of price but pressure from non-OPEC supply, which could mean a more extended period of lower oil prices. While large deepwater projects, estimated to add over 0.5 mb/d this year will proceed no matter the price level, a collapse of shale drilling would see U.S. production declining rather than growing 1 mb/d this year, as the IEA projects. The figure below shows how the 2015 oil price collapse resulted in U.S. shale production switching from a growth rate of 1.2 mb/d/yr to a decline of 0.5 mb/d/yr.

Which is the big difference between now and 1986 or 1998, the presence of a large and growing amount of relatively high cost supply. (A good shale oil well produces over 1,000 b/d for some months; a good Saudi well produces 12,000 b/d for years.) Lower U.S. shale production would certainly be viewed favorably by most oil exporters, but the cost is dear.

This brings us to the crucial question: Clearly the Saudis do not want an extended period of low prices, but are the Russians seeking to avoid assisting OPEC, or do they think prices were too high? Arguably, they might simply want to avoid continuing pressure from other exporters to curb supply to support prices, but they could also be trying to put the U.S. shale sector into permanent decline. (I discount the idea that this represents an effort to either hurt or help President Trump’s re-election bid.) But in any case, today’s oil market implosion is almost certain to be reversed in the near future

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