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Page added on January 28, 2016

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The Oil Crisis And How It Could Overshoot

Business

The day we hit “peak oil” will be a definitive moment in the history of resources and energy consumption. Throughout our lifetime we have been warned of the implications of oil production hitting an absolute maximum; the consequence of which will be the terminal decline of global supply. M. King Hubbert, the author of the Peak Oil Theory, suggested the world might max out in terms of oil in around 1970, a prediction that held true for a long time, saved only by vast improvements in hydraulic fracking technology. Optimists of recent decades have placed new estimates ranging from 2020 all the way to 2050 depending on the industry’s extraction rate, and yet, I’m looking at an oil industry where company and country alike are engaged in a unanimous effort to pull it out of the ground quicker than ever. There is little evidence to suggest crude oil can ‘go off’, although we’ve never let it sit long enough anywhere to find out, but you can’t help but wonder why some of the most developed nations and organisations in the world are entrenched in a price war where oil supply is their greatest weapon.

History has a lot to do it. We’ve had two significant oil supply crises in the last few decades, 1985 and 1998, both of which were caused by nations and conglomerates hellbent on maximum production irrespective of demand. In the preliminary years to these crises, the industry indulged in a vicious cycle  where high production from one forced an equal response from others in a show-of-strength effort to retain market share. Anyone familiar with basic economics will tell you how this ends; extensive oversupply and ultimately a crash in price. The severity of the crash depends on the extent of oversupply in the market and the time it will take for the market to return to its stable equilibrium, so how bad is the one we’re in?

WTI

(Source: Google finance)

In the past three years U.S. oil production has risen by 3 million barrels a day. The response from the rest of the world, led by OPEC’s Saudi Arabia, was to increase its own production to the tune of 2.25 million barrels a day and they don’t show any sign of slowing down. In November 2015 last year OPEC crossed its informal quota of 30 million, pushing production up to 31.6 million barrels a day. It’s a level of production we’ve never seen before. It has the single purpose of running its U.S. shale counterparts into a price they can’t compete with; ultimately forcing them out of business. You have to admire the world’s blissful naivety as we watch from afar, ignorant to a crisis that has been building up for so long, only to  wake up to ask ‘why is the price falling?’. As Robert Mabro wryly puts it in his paper on the 1998 oil crisis:

“If you have been drinking or eating all night do not seek the cause of headaches or stomach pains the next morning.”

Robert Mabro, Oxford Institute for Energy Studies

As I write this article, the sanctions of Iran have been lifted and its own production has come back online. Expected to add 500,000 barrels to global inventories in the first few days, the news has been reflected in a Brent Crude price comfortably settling below $30, a price even lower than oil’s bottom during 2008. So when we talk about the severity of overproduction, we have to consider we may not even be at the peak. Saudi Arabia still has unused capacity and Iran is fighting to regain its title as one of the world’s largest oil producers. The fundamental problem with Iran’s return to the market is the country’s vast ‘el dorado’ oil reserves that can be extracted at a cost per barrel of just $2-3. In comparison, Gary Shilling of Gary Shilling & Co estimates there is a $20 per barrel marginal cost for American shale frackers in the best circumstances across the Permian base.

We talk about the time it might take to return to equilibrium, but OPEC is in disarray and its meeting in December 2015 was a catastrophe. Saudi Arabia, by far the largest producer in the group, is completely disinterested in an arrangement and has not been shy in encouraging the organisation’s members to keep pumping. No-one wants to call the bottom of oil and this crisis looks set to continue far into 2016 and possibly the start of 2017. One thing we can talk about is how the trend will revert, and perhaps we’re in for a sharp change. Firstly, this crisis doesn’t look like it’s going to end softly. If it ends with the default of oil titans the landscape of the industry will be fundamentally changed. It will leave even greater market share in the hands of fewer, and in the wake of the crisis the survivors will be hungry for their margins back. Secondly, resource extraction is a game of two halves; exploiting your current projects, reserves commonly called ‘brownfields’,  and exploring new opportunities known as ‘greenfields’. A price war of this magnitude is threatening the balance sheets of even the biggest industry operatives, you only have to look at Saudi Aramco’s possible IPO and BHP Billiton’s forced writing of assets to know that much is true. These companies are using the capital reserves they have to weather the storm of this crisis, not to invest in new sites or opportunities.

bhp

(Source: Google finance)

If everyone buttons down the hatches instead of investing for the future during the crisis it won’t matter if we come out of it to find our overflowing inventories are back to a normal 60 day level – we won’t have enough new projects to fuel future demand.  As oil demand goes it’s not particularly high now, meaning a turnaround in sentiment and growth in China and the emerging markets will only add to the supply we require. This set of events could lead to a massive overshooting in the oil market, as current and future supply crash below equilibrium. We’d see the opposite symptoms in the markets, namely an unsustainable high oil price. It’s not clear when this oil crisis will end, but we should be careful that when it does, we do not shoot into another.

Market Mogul



53 Comments on "The Oil Crisis And How It Could Overshoot"

  1. antaris on Fri, 29th Jan 2016 10:16 pm 

    Nony. Few things in this world get close to 30 % efficient, so when someone talks about 90% I have a hard time believing that.

  2. Nony on Sat, 30th Jan 2016 1:26 am 

    That’s because it is YOU who has limited understanding of efficiency definitions. What is the efficiency of a steam turbine (just the machine)? 90%+. What is the efficiency of a water turbine. 90%. How about a transformer? Can be 90%. A motor or generator. Easily 90%. These are all energy transformations.

    You are thinking of heat cycles: Carnot, Rankin, Brayton, Diesel, Otto, etc. They have efficiencies of 20-50% (maybe 55% for closed cycle steam engines).

    The 90% for transforming crude to refined products is quite reasonable.

  3. Nony on Sat, 30th Jan 2016 1:29 am 

    See here:

    https://en.wikipedia.org/wiki/Energy_conversion_efficiency

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