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Oil's Only Promise: Volatility

Oil_cash

By Reuters 2015-12-16 19:42:07

Just about the only thing we know about where oil prices are headed over the next few years is that most of the forecasts will be wrong.

The oil market has defied every attempt to fix or predict prices in terms of oil's value to customers, the marginal cost of production, or the price of available substitutes.

"It was to me an economic aberration that oil remained much cheaper than Evian mineral water," the deposed shah of Iran wrote in his memoir justifying his efforts to push for higher prices in the 1970s.

Mohammad Reza Shah Pahlavi thought oil should be intrinsically valuable because it was the source of more than 70,000 different products, including petrochemicals as well as fuels ("Answers to History", 1980).

But more than a third of a century later, crude still sells for less than bottled water, currently on sale at the equivalent of more than $100 per barrel at supermarkets in the United States and Britain.

In the late 1970s, OPEC's Long-Term Price Policy Committee adopted a different approach, recommending that the price of oil should be increased gradually until it was just below the cost of the nearest substitute.

According to ideas popular at the time, alternative sources of energy should cost the same. OPEC identified its main competition as synthetic diesel and gasoline fuels processed from coal.

Since the cost of producing synfuels was thought to be near $60 per barrel, almost $200 in today's prices, that became OPEC's implicit long-run target ("Genie out of the bottle" Akins, 1995).

OPEC managed to push average prices to a high of almost $37 per barrel in 1980, around $107 in real terms, but then the market slumped over the next six years, hitting a low of just $14 in 1986, about $30 in real terms.

As it turned out, the main competitors to OPEC's were not expensive synfuels plants but rival oil producers in Alaska, the Gulf of Mexico, the North Sea, the Soviet Union and China, which were much cheaper.

At other times, economists and oil producers have assumed prices should be set by the marginal cost of production, which in the 1980s was assumed to be the North Sea.

With prices mired below $20 in the late 1980s, OPEC's former secretary-general Ali Jaidah wondered how prices this low could be sustainable:

"I just cannot understand how this low oil price can sustain investment in high-cost oil areas. Someone somewhere must be losing his shirt."

More recently, the marginal producers in the market were thought to be North America's shale firms, and their cost of production was pegged by experts at $80-90 per barrel.

Before prices started to tumble in July 2014, there was increasing confidence among oil executives, analysts and OPEC that $100 had become the new price floor.

It was common to hear statements to the effect "$100 is the new $20" because that represented the marginal cost of shale as well as complex megaprojects.

But as prices have plunged and oil producers were forced to become more efficient it turned out the marginal cost of oil from shale is as low as $50 or $60.

Most major oil companies and members of OPEC are now preparing for a world in which the long-run price of oil is around $60-80.

By now it should be clear that no one has been able to fix or predict the price of oil over the long term (greater than five years) or even the medium term (two to five years).

There is no evidence anyone can accurately and consistently predict the price of oil more than a few months ahead let alone for years or decades in the future.

Forecasts along the lines of "oil prices will be around $X per barrel by 2020" or "oil prices will stabilise around $X because ..." are almost inevitably wrong.

The first response should always be to question what assumptions they are making and why they could be proved wrong.

In the 1970s, OPEC failed to foresee the rise of rival production from the North Sea, Alaska, the Gulf of Mexico, the Soviet Union and China.

In the 1980s and 1990s, OPEC failed to predict the North Sea could continue to produce at real prices of less than $30 per barrel having been written off as a "high cost" area.

In the 2010s, forecasters failed to foresee the rise of production from shale and then its ability to remain competitive at much lower prices than previously assumed.

The other lesson from history is that oil prices, like other commodity prices, are inherently volatile. Volatility is not some accidental attribute of commodity markets, it is their defining characteristic.

Prices have been unstable since the beginning of the modern oil industry when Edwin Drake drilled his first successful well in Pennsylvania in 1859. 

Writing less than 20 years later, one of the first historians of oil observed: "Petroleum had no certain value, no determinate value. The fact that it sold for 50 and 25 cents per gallon proves nothing. It sold for that in 1859 but the first day's production broke the market" and sent prices tumbling ("Early and later history of petroleum" Henry, 1873).

Oil prices fluctuated wildly in the 1860s from several dollars per barrel to just a few cents, and the extreme volatility has continued unabated ever since. ("Pennsylvania petroleum 1750-1872" Giddens, 1947)

In the last 150 years, various combinations of private companies and governments have repeatedly tried to bring order to the market yet all have failed.

From Standard Oil in the late 19th century, through the "As-Is" agreement among the major oil companies signed at Achnacarry Castle in Scotland in 1928, to the foundation of OPEC in 1960, there is no evidence anyone has managed to dampen the extreme, cyclical behaviour of oil prices.

In fact, oil prices have been more unstable in the 55 years since OPEC was founded than they were in the previous 55 years.

It is tempting to blame the recent slump in oil prices on OPEC for failing to reach an agreement on limiting output.

But the truth is stability has been the exception rather than the norm. Neither OPEC nor private companies have ever managed to stabilise prices except for very short periods in very special circumstances.

It makes no sense to talk about "long term" or "equilibrium" prices since the price of oil depends on too many factors which are all dynamic.

Oil producers and consumers must adapt to prices as they find them.

Flexibility and the ability to survive through the price cycle are more important to oil producers and consumers than flaky forecasts about where prices are going over the next 3, 5 or 10 years.

The long-term price of oil is literally unforecastable. The only thing that can be said with absolute certainty is that oil prices will continue to defy the expectations of experts.

By John Kemp; Editing by Jason Neely

The opinions expressed herein are the author's and not necessarily those of The Maritime Executive.