Consciousness of Sheep
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Major oil price volatility has occurred on three occasions in the last century – the 1920s, the 1970s and today. Those periods resulted in severe economic disruption and the collapse of political consensus. There is a simple reason for this – price volatility makes capital investment difficult. There is simply no means of developing a credible business plan if the cost of energy and transportation could more than double overnight.
This is as true in the oil industry itself as it is in the economy generally. Far better to invest capital in asset bubbles (as Norway’s sovereign wealth fund is doing) than to risk developing $100 per barrel oil that can only be sold for $40 by the time it is recovered.
Historically, the response to oil price volatility has been the development of cartels. The earliest attempt at price control was Rockefeller’s monopoly ownership of the US oil industry in the late nineteenth century. By leaving reserves in the ground, Rockefeller could control the market price. Only if demand for oil exceeded the reserve would he lose control of the price. This began to happen in the years leading to the 1914-18 World War, as navies around the world began to switch from coal to oil. The development of petroleum vehicles during the war ushered in the price volatility of the 1920s as the world swung from gluts to shortages; and helped to bring about the 1929 crash, the ensuing depression and ultimately the Second World War.
The development of the US oil industry during that conflict paved the way for the second – Texas Railroad Commission – cartel that used untapped US reserves to regulate global prices during the unprecedented economic upswing between 1953 and 1973. By the early 1970s, however, global demand exceeded US reserves, ushering in the period of price volatility and subsequent economic and political crises of the 1970s and early 1980s. This came to an end when the OPEC cartel began to use its excess reserves to control world oil prices – a cartel that continued until 2005 when global production of conventional oil peaked. Once again, global demand had overtaken global reserves.
The period since 2005 has seen extreme price volatility. At the end of the last decade, prices soared above $100 per barrel, before plunging down to $35 per barrel in 2014. This left a lot of stranded capital – particularly in the US shale (fracking) industry – as anticipated returns above $100 per barrel have evaporated. It is notable that for all of the claims about shale oil and gas technology, which should be universal, fracking remains a US phenomenon.
The recent OPEC-Russia production freeze has helped lower the world glut of crude oil that in 2016 looked set to overwhelm global oil storage capacity. In the last few months world oil prices have crept up toward $60 per barrel once more. However, there is considerably less enthusiasm among investors to throw money at new recovery projects this time around. The reason, in a word, is volatility.
Writing in the Financial Times, Ed Crooks, reports that:
“ConocoPhillips, the largest US exploration and production company, has ruled out investing in projects that need an oil price of $50 or higher to make a profit, as it attempts to raise shareholder returns after years of poor profitability…
“Ryan Lance, Conoco’s chief executive, said the company was seeking ‘returns over growth’… ‘You don’t even get through the door unless you are below $50 cost of supply, and you don’t really get to the table in the capital allocation fight unless you are $40 a barrel or below,’ he said.”
Following the price collapse in mid-2014, too many investors had their fingers burned to risk diving back into the shale patch just because prices have begun to trend upward. In large part this is because few are convinced that OPEC-Russia is capable of developing a new cartel to control global prices. The economies of those states are too dependent upon oil income to maintain their production freezes for much longer. The temptation to cash in on $60 per barrel oil in an attempt to head off domestic economic and political woes is likely to be far stronger than the desire to cut production.
For potential investors in the US, prices blipping above $60 per barrel will simply not cut it. It will take a sustained period of rising oil prices – most likely above $100 per barrel – before we see widespread interest in investing in shale again. Even then, the memory of the economic collapse that occurred last time around is likely to put the brakes on investor exuberance.
The ConocoPhillips decision to reign-in its development projects is likely to set the trend for the immediate future. However, within it, it carries the seeds of the next big spike in prices and the next major economic collapse. This is because this time around there is no giant oil reserve elsewhere in the world on which a new cartel can be created to stabilise prices. Instead, the lack of investment today sows the seeds of an oil shortage tomorrow. Exactly when that shortage will materialise is a matter of conjecture. But, given the short lead-in times for shale oil recovery, it will not be too far away. When that day arrives, we will look back on today’s economic and political woes as a golden age of affluence and harmony.
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