Oil price lessons from 1983

by Bluford Putnam, chief economist, CME Group

Crude oil prices dropped precipitously in the latter part of 2014, raising challenging questions about where they might go in 2015. Undershooting well below a mythical fundamental equilibrium price is a distinct possibility if history is any guide. In the early 1980s when oil was trading around $30/barrel, up from $3/barrel in 1972, after two rounds of Opec price hikes, many analysts at the time thought oil could only go higher, so impressed were they with the power of Opec. 

As I wrote with my co-author, Lee Thomas, in February 1983, in the pages of Euromoney: “In the oil market, the forces of conservation and substitution have developed slowly, but ultimately they must be irresistible. The real question is not why the price of oil will fall, but why Opec was so successful for so long.” 

We argued then that oil was headed sharply down, below $25/barrel, and probably much lower and for a long period of time.

This time around, we have had a slow but powerful supply response to $100-plus/barrel oil prices. The US and Canadian energy production boom started in 2006-2007 and have kept apace since then. 

Growing supply, though, was countered in no small way by continued strong demand from China and other emerging market (EM) countries at the start of the production boom, and then later by rising geopolitical tensions in Libya, Syria, Iran, etc, that served to mask any downward price pressures.  In the last few years, however, China’s rate of growth has materially decelerated, and growth has slowed dramatically in most other EM countries as well, not to mention the economic stagnation that grips Europe. 

We would argue that the global growth deceleration is the fundamental to the recent drop in the oil price, but not the most important long-run cause. That is, our estimate is that supply, in the form of the production boom, is probably due 70% of the causality allocation, and demand factors only 30%.

When it became clear that despite worrisome developments in the Middle East, oil production was either coming back online (Libya, Iraq) or not being materially impacted, many longer-term investors, such as pensions and endowments, not to mention retail investors, began to shift their asset allocations back to a rising stock market and away from directionally bullish energy funds, including exchange traded funds and exchange traded notes, that were index-linked to a positive view on global energy prices.  The key point here is that if one analyzes only the physical supply/demand factors for oil, one is taking a huge risk of misinterpreting market dynamics. Asset allocation shifts can be powerful, and during 2003-2010 there was a shift toward bullish energy allocations by institutional funds and retail investors. 

That trend has reversed, and it may have a year or more to run. Under this scenario, the price of oil can go well below any perceived fundamental supply/demand equilibrium, driven by long-term and evolving asset allocation decisions. A related observation to make is that the recent fall in oil prices begs the question of whether supply will adjust. Indeed, if one focuses only on the actual production trends set against demand trends based on economic growth, one might be tempted to argue that sooner or later production cutbacks in response to lower prices would halt the current downward momentum. 

Oil production, however, tends not to respond to short-term price movements. A considerable proportion of oil production costs are in the capital investment phase, and these costs are often incorrectly (from an economics perspective) partly included in the perceived marginal cost of producing the next barrel of oil.  In fact, production dynamics are much more complex, actual marginal costs are much lower than they might appear, and short-term production cuts are very unlikely. Put another way, cash flow is king. If a producer shuts down production, this will cost cash – shutting down is expensive, and once shutdown, there may be no money to pay the bills that keep coming.

Another sign of myopia among many oil analysts is the failure to consider substitution effects. Oil, or the refined product derived from it, competes with other sources of fuel.  Take natural gas in the US. The production boom has driven prices down. Indeed, if one gives you one US dollar to spend on US energy, one can get over 200,000 BTU’s of energy from natural gas at December 2014 prices, and only around 100,000 BTU’s at a $60/barrel price. This sets up some powerful economic incentives, but it also takes billions of dollars of investment and three-to-five-year time horizons for markets to realize what is happening. 

Basically, watching supply substitution dynamics is like watching paint dry – but under most conditions, paint will eventually dry – and those that ignore the substitution effects do so at their peril.

Of course, no energy analyst can develop scenarios with considering geopolitical risks, even if they were not impacting the oil price in late 2014. The developments in 2014 in the Middle East and Russia probably held up the price of oil at $100-plus/barrel much longer than otherwise would have occurred. But even with growing production from oil and natural gas, especially in North America, one should never ignore the low probability, but high impact potential, of surprise oil supply shocks. 

Still, our base-case scenario is that the role of traditional bullish-oriented investor groups, from pensions to endowments to the retail sector, have not completed the process of allocating assets away from indexed energy funds and towards bonds or equities.  Thus, absent a major and long-lasting supply disruption, there may well be some more downward pressure on oil coming over the course of 2015.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.