The Oil Price War

In February of 2014, a barrel of Brent crude, the world’s leading benchmark, fetched over $100/barrel. Today, the same barrel of Brent crude goes for $30/barrel. Over the course of the past two years, supply overwhelmed demand and a massive oil glut emerged to depress prices.

High prices in the early 2000s coincided with a technological explosion that combined horizontal drilling and hydraulic fracturing. This combination, predominately exploited in United States shale plays, drastically increased domestic output. West Texas Intermediate (WTI), the domestic crude benchmark, historically traded at a discount to Brent crude. The two benchmarks were almost equal in 2015.

The increase in United States oil production was noticed by the Organization of the Petroleum Exporting Countries (OPEC). Instead of curbing production to prevent a supply surplus, OPEC ramped up production and created a price war to defend its market share. The oil price war has certainly become one of attrition, as Saudi Arabia is expected to register a 13% trade deficit in 2016, exploration and production company bankruptcies are expected often, and price rebounds are nowhere in sight.

OPEC countries have begun to rethink their production strategies. For the first time in 15 years, Saudi Arabia, the essential OPEC leader, met with Russia to discuss a production cap. If a deal goes through, Qatar, Venezuela, and most recently Nigeria, have all agreed to freeze production at January levels. The deal, however, is far from likely, as Iran argues it should not be forced to freeze output at the same levels as other OPEC countries. Iran has been unable to export oil as a result of economic sanctions. Now, with those sanctions lifted, Iran looks to ramp up production and regain market share.

 

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http://www.bloomberg.com/news/articles/2016-02-21/for-opec-path-from-oil-freeze-to-output-cuts-is-far-from-clear

 

Time will tell if OPEC and Russia are able to successfully strike a deal. Even if they do, it is uncertain how global supply will be affected. With so many wells temporarily shut down, any significant price increase will result in domestic and international producers bringing wells back online and again increasing supply. What can not be precisely evaluated is how the oil price war will affect regional conflicts in the Middle East. Conflicts in oil producing countries such as Syria, Libya, and Yemen have already caused unexpected production disruptions. If prices continue to stay low, tensions will continue to mount.

Domestically, shale producers have struggled to keep their balance sheets in check. Many producers took on huge amounts of debt when oil prices were high. Today, many of these loans are coming due and companies will face difficult restructurings. Certain projections expect a wave of mergers and acquisitions similar to the late-1990s to sweep the industry. For now, price volatility has created stagnation, as energy mergers and acquisitions were down 30% in 2015.

The outlook for many is bleak right now. But the energy industry is cyclical. Demand will increase, as low prices encourage consumer spending and the Chinese economy stabilizes. Supply will decrease, as expensive production fields become illogical to produce. All of this will undoubtedly happen; it is just a question of when.

 

 

Sources

http://www.bloomberg.com/quote/CO1:COM

http://www.ft.com/cms/s/0/71f9de36-d6b7-11e5-969e-9d801cf5e15b.html#ixzz40rLcTVlJ” target=”_blank”>http://www.ft.com/cms/s/0/71f9de36-d6b7-11e5-969e-9d801cf5e15b.html

http://www.reavesassetmanagement.com/UploadedFiles/Reaves%20Asset%20Management%20-Fourth%20Quarter%202015%20Commentary.pdf

http://jia.sipa.columbia.edu/online-articles/war-and-the-oil-price-cycle/

http://www.bloomberg.com/news/articles/2016-02-21/for-opec-path-from-oil-freeze-to-output-cuts-is-far-from-clear

http://english.alarabiya.net/en/business/energy/2016/02/22/MENA-oil-exporting-countries-seen-to-incur-twin-deficits-.html

9 thoughts on “The Oil Price War

  1. This is an interesting analysis of the effects that the current oil supply glut is having on the global economy. You mentioned that exploration and production companies are expected to flounder moving forward. Indeed, upstream investment in global oil exploration and production is shrinking in response to the plummeting prices. Capital expenditure on exploration and production dropped by 24% in 2015, and is expected to fall by 15% in 2016. Investment in the industry is at its weakest level in 30 years.

    Insufficient investment increases the risk of an oil price spike once the industry has stabilized. As Fatih Barol, Executive Director of the International Energy Agency, puts it: “It is easy for consumers to be lulled into complacency by ample stocks and low prices today, but they should heed the writing on the wall: the historic investment cuts we are seeing raise the odds of unpleasant oil-security surprises in the not-too-distant-future.”

    http://www.iea.org/newsroomandevents/pressreleases/2016/february/global-oil-supply-growth-plunging-with-us-taking-biggest-hit-for-now.html

  2. It is interesting to see what happens once Iran begins ramping up oil production after its sanctions are lifted. If OPEC does not strike a deal with Russia, or Iran does not have to follow the limitations, will their increase in production have any effect on the world market? Will prices decrease again? If so, other oil producers will be in even worse shape. It is interesting to see what Iran decides to do and its repurcussions.

  3. I wonder what the impacts – both positive and negative – are on Iran should the country continue to push back against the group slowdown. Of course, Iran is looking to increase its market share and understandably fears the loss they could incur by producing less than one-tenth of what Saudi Arabia produces. But ramping up production at this time certainly does not promise success. As the oil industry slips deeper and deeper into its current trough, prices are decreasing and firms are struggling. As you write, overproduction plays a major role in this downward spiral – and just because Iran produces oil does not, by any means, promise that oil will be sold. So Iran should bide its time and wait to increase production until the market steadies. Any market share it gains during this period could be highly volatile, so I wonder why Iran does not simply wait it out. Sure, they feel the need to flex newfound freedom of production, but it is not a smart decision given the shaky nature of the market.

  4. While the oil market is the main worry right now, it is important to think about what will happen to other related markets. In the US, the ethanol industry is taking a beating due to the recent crude slide. This $40 billion industry has seen profit margins shrink as cheap crude is putting downward pressure on the price they can get from refiners who blend the ethanol into gasoline. Ethanol companies have also experienced a price increase during this past year for their main input, corn. Ethanol futures have dropped as well as the stocks of the major ethanol producers Green Plains Inc and Pacific Ethanol Inc. However, there may be a light down the tunnel. In 2007, a bill was passed that essentially promoted the increased use of alternative fuels like ethanol. In 2015, the EPA is going to be making a judgement on how much ethanol will be required to be blended into gasoline, the current level is up to 10%.

    Sources:
    http://www.wsj.com/articles/falling-crude-prices-force-ethanol-makers-to-take-it-on-the-chin-1420238100

    • From an environmental standpoint, the collapse of the ethanol market would be a good thing – producing corn is sufficiently energy-intensive, as is fermenting corn, while the total yield is low, that on net it costs more energy than it saves. However each corn-producing state has two senators, and while the farm vote is small, on this issue farmers vote as a block, so that a large minority in the senate and a significant minority of the House view support as essential to reelection, irrespective of party affiliation. Hence the mandate for 10% gasohol.

  5. Well written blog, thank you. It’s interesting to see the role of OPEC in the current oil war compared to its role in the ’70s oil crisis. Back then, OPEC was able to single handedly pump up oil price, reap huge amounts of profits from other countries and lend the money back out at high interest rates to countries seeking a loan, which pretty much included most countries and the third world countries especially hit hard. Today, as a result of the U.S. shale boom and technology advancements worldwide, OPEC doesn’t have the same pricing power anymore. Yet it refuses to lower output, not only because its member countries want to remain market leaders, as the blog mentions, but also due to the cost associated with stop drilling and fracturing. So the question next is how OPEC can shift its production and investment strategies to meet demand with more flexibility. The blog ends with the perception that outlook is bleak. My question is, what are the consequences, on a global scale, if it takes a long time for OPEC to scale back, whether it’s by striking a deal with Russia or realizing the importance of sustainability? What can we expect of the structure of OPEC after the storm passes?

  6. Be careful in assuming that OPEC is anything more than a club for oil ministers to periodically shoot the breeze with one another, in some attractive location. Is any single member big enough to themselves sway prices? If not, then when (say) Saudi Arabia pushes for higher prices (which means production cuts), what we in fact observe is that smaller members cheated (to the extent that they had unused capacity). There is no mechanism to hold the cartel in place, though in the past the biggest 3-4 members had a large enough share of the market that price elasticities of demand worked in their favor.

    Today however that’s not true. The impact of the House of Saud is smaller, and production globally more diversified. So if Saudia Arabia cuts production, their revenue falls. Since they urgently need revenue, they instead boosted production.

    In other words, the claim of OPEC to function as a cartel is not in fact what we observe in the behavior of individual members. See “Low Oil Prices: Not a Saudi Conspiracy” for my own effort to use estimates of the price elasticity of demand for oil to try to demolish this shibboleth.

  7. The article mentioned that the oil industry is cyclical, and while that is true, and eventually supply and demand will become more balanced, I think that the oil industry is at the beginning of its end, OPEC especially. Not only are they feeling increased pressures from American natural gas production, but they will soon be facing pressure from the shift towards renewable energy sources. It has already been established that a holding pattern is unsustainable, from both an environmental and availability perspective. Oil companies need to get their foot in the door of renewable energy is they are to survive.

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