Oil might soon be $25 a barrel or less

by Bluford H Putnam and Lee Thomas
February 1983

Market forces have turned against Opec. Even an economic upswing will not make the industrial countries buy oil in the old lavish way. And some of the suppliers, already in trouble, are fiercely competing to sell.

An oil price of $25 per barrel or less – perhaps much less – seems likely. The cause of this sharp fall is not primarily the world recession, though the current slowdown may well have precipitated the crisis. We will probably not see an Opec price of any consequence until long after the economies of the world have shaken off their current malaise.

In the long run the real price of any commodity depends on underlying demand, and on the costs of satisfying that demand, using substitutes. In the oil market, the forces of conservation and substitution have developed slowly, but ultimately they must prove to be irresistible. The real question is not why the price of oil will fall, but rather why Opec was so successful for so long.

Some researchers argue that the only successful cartel is one with only one member who controls 100% of the market. Others argue that even this is not enough. There must also be an absence of competing products.

Opec now controls well under half the world’s oil supply. And there are numerous alternative sources of energy.

Opec was able in 1974, and to some degree again in 1979, to influence the supply conditions in the oil market by a much greater proportion than its share of the market would suggest. It had the help of the US, Canada and the Soviet Union.

Political conditions in the US and Canada led to energy policies which strengthened Opec. Both countries attempted to shelter their domestic markets from the effects of Opec’s price rises. This destroyed incentives to conserve oil (demand side) or to increase domestic exploration and production (supply side).

The Soviet Union, an oil-producer, uses oil as a tool to subsidize and control the economies of Eastern Europe. Until recently, when everything turned sour economically in Eastern Europe, and the Soviet Union needed cash as well, it was controlling its oil production in support of the Opec price.

Thus, major parts of the world oil market acted in support of Opec in 1974, and to a lesser extent in 1979. With this kind of assistance, the cartel appeared to work. Appeared is the right word, however, for as the US and Canada have shifted to more competitive oil pricing policies, and the Soviet Union has faced more difficult conditions in its backyard, Opec has been forced to operate in an increasingly competitive world. Energy policies in the US, and to a lesser extent in Canada, now promote incentives on both the demand and supply sides. These factors will keep Opec at bay long after the recession has ended.

The inflationary 1970s did much to distort relative prices among goods. The table compares the US consumer price index with the price of Saudi Arabian oil over the last 30 years. Between the 1952-55 and the 1981-82 periods, the relative price of oil has increased fivefold, compared to the prices of all goods in the consumer price index.

Restoring a reasonable relationship between oil and other prices

The trebling of the real oil price since 1975 is all the more remarkable because relative commodity prices were generally falling. In the long run, primary commodity production, including oil and metals extraction, probably represent mature industries which will claim a decreasing portion of future world GNP. The growth sectors in the developed economies, especially services, computers and communication technologies, are not commodity-intensive. The dramatic shift in the relative oil price is surprising. What is not surprising is the fact that it has set in motion supply and demand changes which will restore oil prices to a more reasonable relationship with other prices.

Some simple calculations indicate just how far oil prices could fall. If the relative price fell to the average for the 1952-60 period, with a complete collapse of Opec, the price of Saudi Arabian crude could be between $6 and $7 per barrel. But some long-term trend increase in the relative price of oil may have occurred. If the 1975 price of oil is taken as a benchmark – and this allows for the first Opec price shock – then a $20 per barrel price emerges.

All these calculations were pointing to sharply lower prices than the benchmark $34 per barrel prevailing early in 1983. The supply and demand adjustments resulting from recent prices reinforced this impression.

A look at the demand side shows how much economizing has taken place since energy prices began to soar. Oil consumption in the major industrialized countries fell from 39.2 million barrels a day in 1973 to 34.9 mb/d in the fourth quarter of 1981. World recession is one reason, but not the dominant one, as we can see by adjusting oil consumption figures for changes in industrialized countries’ output of goods and services. In fact, between 1973 and 1981, the last year for which statistics are available, the OECD ratio of oil consumption per dollar of GDP has fallen by a remarkable 25%. This trend seems to be accelerating, rather than levelling off.

The supply-side response has been no less dramatic. Between 1973 and September of 1982, Opec production fell by over 40% during the same period, non-Opec production rose by almost 35%. So Opec, which controlled two-thirds of the world’s crude oil production in 1973, controlled less than half by the end of 1982.

Lower prices might make North Sea oil unprofitable

In the long run, potential and actual new entrants into energy production impose a ceiling on oil prices, unless Opec is willing to accept an ever-decreasing market share. This means that though the current state of each Opec country’s production level and similar factors are the standard topics for an oil price discussion, they just may not be relevant. If the cartel fails to constrain world supply, then a competitive market solution cannot be prevented. In this case, Opec oil production is not even the dominant factor because Opec produces oil at well below the costs of marginal entrants. A more critical issue is, for example, the cost of North Sea oil, since marginal costs there are some of the highest in the world. Indeed, if a sharply lower price forecast proves correct, North Sea oil may become unprofitably.

Some analysts feel compelled to consider political turmoil in the Middle East and the possibility of supply disruption. However, the price of oil sold in long-run contracts, as opposed to the spot market, has embodied in it a supply risk premium. The chance of an oil supply disruption is real enough to affect long-term contract prices. This also means that it provides incentives for exploration above and beyond those incentives that would be provided by a stable market. Thus the world is not unprepared for this possibility.

There are three factors which indicate that oil prices will fall sooner, rather than later. The first is the normal seasonal pattern, which indicates that there will not soon be a reprieve for the already harried oil producers.

Another is the debt problem of many oil-producing countries. Mexico, Venezuela, Nigeria, Algeria and Indonesia are having financial difficulties. These problems have various solutions; pumping oil rapidly is one.

Even $25 a barrel seems too high

The most important immediate factor may be changing expectations. So long as businessmen thought future oil purchases would cost them more than buying immediately, they laid in the supplies. And the oil-producing countries with limited reserves withheld supplies, because they expected higher prices. Crude oil stocks have been variously estimated; they are now about 90 days’ supply, and have been falling for about two years. A stock reduction to 70 days’ supply – about the level which existed before Opec – would depress demand this spring even if there were world recovery. This would come at the same time as the normal seasonal slowdown in oil consumption. There might also be extraordinary selling, as producers realize that prices are past their peak. A sellers’ panic may develop.

If one steps back to review the last 30 years, and then contemplates the power of the market-place, even $25 a barrel looks high.

Bluford H Putnam is chief economist, Stern Stewart Putnam and Macklis, New York; Lee Thomas is an economist, The Chase Manhattan Bank, New York.