Why have oil prices slumped … and will they recover?

TRIPLE-DIGIT oil prices, it turns out, were not as sustainable as the industry thought.

In retrospect, last summer might look like a high watermark for global oil prices, at least for a while. In June 2014, Brent crude, a high-quality grade of oil that is used as a benchmark for the global price, was trading above $110 a barrel – high by historical standards, but not the wallet-busting level of 2008.
The price seemed justified. Islamic State (IS) terrorists had just captured Mosul, a town in the north of Iraq, one of the world’s biggest oil exporters. Other producers in the Middle East were also struggling. Sanctions against Iran have removed just over 1 million barrels a day from its supply since 2011. Syria’s war knocked out most of its production. Almost all of Yemen’s and South Sudan’s oil was shut in because of conflict too.

Then there was Libya. Its oil is prized by refiners, especially in Europe, because of its high quality. So disruptions in Libyan supply have an effect on prices that is disproportionate to the amount of oil it can produce – just 1.6 million barrels of a global market that sees about 90 million barrels change hands every day. In the political chaos that followed the 2011 war to topple Muammar Gaddafi, oil production recovered quickly but then collapsed again in 2014 when men guarding crude-export terminals shut them down.

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Prices retreat

As it became clear that IS in northern Iraq posed no grave threats to oil installations in the south of the country, oil prices began to retreat. Then, suddenly, the strike at the Libyan oil ports ended and its exports surged. By October, a barrel of Brent was trading in the $80s. Producers from Brazil to Russia were starting to worry. All eyes turned to Opec, the Organization of the Petroleum Exporting Countries, whose members supply about a third of the world’s oil but own four-fifths of its reserves. To stop the slide in oil prices, it needed to do what it had done repeatedly in its past: cut some of its own production to tighten the world’s supply. Instead, a November meeting ended with a commitment to keep output stable – an implicit challenge to the oil market to move even lower. Minutes later, prices began to slump. By the end of January 2015, Brent was beneath $50 a barrel.

The big drop in oil prices is chiefly a consequence of basic supply and demand – what market watchers like to describe as “the fundamentals”. The world is now awash with oil and people are using it more sparingly than they were. A shift in mindset has accompanied this change, and it has seen economic law trump geological law. Ten years ago, “peak oil” was the pet theory: output of oil, a finite resource, could not keep up with the relentless annual increase in demand for it. Geology – the rocks – just wouldn’t allow it. As this view has faded, economics principles have returned to the fore: if the price is high enough, supply will increase and demand will fall.

The truth lies somewhere in between. High prices have yielded new supplies, especially from North America. This extra oil production has amounted to about 3 million barrels a day and is still growing. It’s been enough to offset the losses in supply during the turbulence seen in the Middle East and North Africa. That’s why Opec wants the price lower: its members can extract oil more much cheaply than North America’s unconventional oil producers can, so it hopes a period of low oil prices will recoup some of the customers Opec members have lost to these new rival suppliers.

Demand for oil has softened, too – at least in some parts of the world. In Europe, the financial crisis has weakened the economy and, in tandem with long-standing conservation measures, this has cut demand for oil. Across the rest of the developed world, including the US, consumer behaviour seems to be changing. Young people are less interested in cars, people are driving less, internet shopping has replaced trips to the mall and telecommunications allow more people to work from home. Engines are also becoming more efficient, burning less gasoline and diesel to cover the same distance.

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China is changing

China, which was responsible for a big surge in global oil demand between 2000 and 2010, is moving into a new phase as well. Economists say its “investment-led” economy is maturing into a “consumer-led” one: the onus for economic growth will no longer be on vast infrastructure projects, but on the burgeoning middle class, who will spend their growing wealth. Oil demand will keep rising, but not as quickly as before. New laws to make cars go further for less are coming in China, too, and the country has emerged as a leader in green technology, with a booming export business in solar panels – all part of the country’s big transition.

But no-one should mistake another oil-industry cycle for a permanent shift. If high prices were responsible for more supply and weaker demand growth, a period of low oil prices should reverse at least some of this. That’s always been the way. A spike in crude prices in the 1970s caused a national crisis in the US – President Jimmy Carter even put solar panels up on the White House, reflecting the mood. His successor, Ronald Reagan, whose “economic miracle” was underpinned by cheap oil in the 1980s, promptly took them down.

Furthermore, global oil demand may be rising more slowly than it was, but it is rising all the same. Last year, it increased by about 700,000 barrels a day. The forecast for 2015 is 1.2 million barrels a day. By 2040, says the International Energy Agency (IEA), a group representing Western consumers, global consumption will probably have reached about 104 million barrels a day, a jump in demand that would require adding almost another Saudi Arabia and Iraq to world supply. In the meantime, as the world’s economy recovers – helped along by cheaper oil, the sine qua non of modern wealth creation – the pace of demand should pick up again. Expanding economies create more jobs and mean people buy more stuff, and all of it – a mobile phone, a unicycle or an espresso machine – depends on oil.

This might not rescue prices in the short term. Oversupply has forced a lot of barrels into storage, so that oil has to be used before demand and supply start to match again.

Clearing the decks

But the market will eventually clear the decks. It always does. And lurking in the background are other forces that could come to bear. India’s economy, for example, could soon enter the same kind of investment-led economic growth phase that did so much for China. If India’s oil consumption were to grow in the next 10 years as fast as China’s did between 2003 and 2014, its demand would rise by something like 4 million barrels a day of oil – like adding another major economy to global oil needs.

As some oil supply is shut in because of the low oil price, the supply-demand balance will naturally tighten too. As companies commit to spending less over the next couple of years, the seeds of the next rally in oil prices are already being sown. That’s exactly what happened in the 1990s, when cheap oil brought a period of consolidation in the oil industry and big companies swallowed rivals, spending their cash on stocks and shares, not drilling rigs. It left them short when demand soared a few years later.

There’s no need for that to happen this time. Most companies are far more optimistic about the long-term future for oil, which will remain the lifeblood of mobility, trade and economic growth for decades to come. In fact, the latest correction has returned the oil price to roughly where it should be – in economist-speak, a “reversion to the mean”. Since 1970, oil prices have averaged $51 a barrel, once you adjust for inflation.

What’s most important for the oil industry is that prices remain stable, not wildly fluctuating as they did in 2008-09 (see Figure 1) and as they have in the past year. It seems possible now. Once the market has found its bottom price and the reaction from suppliers (cutting back) and buyers (buying more) is visible, oil should eventually find a decent trading range. If prices are too high they will just encourage all the costly oil supply to come back on stream, while curbing demand. If they are too low, they will do the opposite. Given that a lot of the extra oil comes from costlier sources, like US tight-oil fields or the Canadian oil sands, crude will probably find a range somewhere between $65 and $75 a barrel.

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A Goldilocks outcome

That would be a Goldilocks outcome: “not too hot, not too cold, but just right”. A price high enough to keep companies investing, but not so high that consumers are turned off; and not so low that drillers stop drilling and buyers gorge themselves.

Whatever happens to the price in the immediate future, though, oil isn’t going anywhere. More of it is needed every day and finding it is getting harder. The IEA thinks companies will need to spend $48 trillion in the next 20 years to meet the world’s growing energy needs. That will require a new generation of world-class engineers – and their expertise will be needed sooner rather than later.

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