Crude Behavior: What Are Oil Prices Telling Us?

 

In the eight weeks from early August to mid-September, America's benchmark oil price (West Texas Intermediate) fell from the mid-$80s a barrel to the mid-$60s – the lowest level in 32 months. Prices have rebounded slightly since. For many in the Oil Patch, however, a price starting with a "6-handle" was shocking. Is it a wake-up call that the business is changing?

Oil price volatility

Oil price volatility is nothing new for the petroleum business or those in it. Many remember the price crash in late 2014 when Saudi Arabia prioritized retaining its global market share over supporting OPEC's official oil price. That wreaked havoc on the industry, costing thousands of jobs, bankrupting numerous companies and disrupting America's effort to become "energy independent."

The 2014 episode repeated the 1970s-1980s oil price boom and bust. In the late 1960s, when the U.S. reached peak oil production, pricing power shifted to OPEC, which controlled the next barrel of oil. OPEC used its new power politically. Its leaders backed Egypt and Syria in their October 1973 Yom Kippur War with Israel. It enacted an oil embargo against countries supporting Israel, forcing the U.S. and other Western nations to ration oil supplies to their citizens.

The 1973 oil embargo demonstrated the industry's new reality. For the remainder of the '70s and early '80s, OPEC reigned. It set global oil prices, driving them from $3 to $12/barrel. Four years later, when the Iranian Revolution commenced, the world's oil supply lost five million daily barrels, sending prices skyrocketing to $40/barrel. It was boom times.

Saudi Arabia's OPEC partners happily grabbed extra dollars by cheating on their quotas. Saudi Petroleum Minister Sheikh Zaki Yamani supported OPEC's official price by cutting the Kingdom's production to a 20-year low of two million barrels per day. When he unleashed his country's idled supply to punish the cheaters, the price crashed below $10 a barrel.

Misreading OPEC politics and global oil market dynamics cost Yamani his job. In 2014, Saudi Oil Minister Ali Al-Naimi once again used Yamani's playbook to end soaring oil prices.

Booms & busts

Oil booms and busts mark the history of the industry. They're part of its mystique. Images from the early days often show black gold shooting into the sky and drenching smiling wildcatters. The volatile industry created flamboyant personalities like speculators Dad Joiner, H.L. Hunt and Glenn McCarthy, not to mention industry daredevils like oilwell firefighter Red Adair.

Booms and busts come from the long lead times needed to add more oil supply. Shortages drive prices up, dampen demand and stimulate drilling. Surpluses lower prices, leading to greater consumption and less exploration. People tried to harness this volatility over the years, but with little success.

Why did oil prices drop recently but then rebound? Answering the rebound question is easy. Hurricane Francine shut Gulf of Mexico output which, coupled with prospects of a continuation of Libya's oil export shutdown, tightened the supply/demand outlook. Tighter markets raise oil prices.

The current debate

For the foreseeable future, oil prices will swing on industry developments, economic news and geopolitical tensions. Oil prices respond to population and economic growth trends and the health of the global petroleum industry in the long term. These long-term trends have marched steadily higher and are expected to continue rising.

Short-term oil prices, however, are buffeted by views of near-term economic activity and actions that stimulate or dampen it. Will there be a recession? Or can central banks, by cutting interest rates, prevent it? That's the current debate.

The latest U.S. economic data sends conflicting signals about a recession's likelihood. Overall inflation numbers are improving, but the core inflation data is going in the opposite direction. Labor market data raises troubling questions. The August employment report showed a smaller increase than expected. Moreover, the annual revision of the nation's employment numbers showed that in June 2024 there were 800,000 fewer jobs than previously reported. Are we already in a recession?

In Europe, the economy is weaker than expected with Germany, the continent's primary economic engine, showing little or negative growth. High energy costs hurt Europe's competitiveness, forcing leading companies such as Volkswagen to revoke its historical commitment against laying off workers from Germany's largest auto plant. Such a move shows how challenged European manufacturers are in the current environment. Will lower interest rates improve their prospects?

China's centrality

Recently, the International Energy Agency and OPEC cut their global oil demand forecasts for 2024 and 2025 for the second time. The cuts are driven by continued weak oil consumption data from China, the key market for global energy and natural resources.

Around 2000, oil production in China peaked, and it became an oil import behemoth. The shift drove global oil prices to $145 a barrel in mid-2008 when the Great Financial Crisis began. Over the past decade, China's oil consumption has increased by an average of 600,000 barrels per day annually, representing more than 60 percent of global oil demand growth.

The country's one billion people, their rising incomes and living standards, and the nation's economic policy promoting exports and domestic industrialization drove China's oil increase. Those trends have slowed in recent years, following their rebound from the pandemic shutdown. Will the growth re-accelerate?

The IEA believes the slowdown in China's oil consumption is permanent. OPEC and international oil giant ExxonMobil disagree. Both see the near-term problems as temporary. Global population continues to grow and people still desire better living conditions helped by oil. Those trends will not be smothered for long.

The IEA projects global oil demand to peak before 2030 with supply growing as companies continue to invest. This results in an eight-million-barrel/day glut by 2030, which the IEA believes will "upend" OPEC's efforts to manage the global oil market and usher in an era of lower oil prices. The IEA says the level of spare productive capacity is unprecedented outside of the coronavirus pandemic.

It believes the glut is partly due to the shift to electric vehicles and away from gasoline-powered cars. Its view assumes forecasts for rapid EV adoption are correct, although recent data shows sales slowing. The IEA points to China EVs accounting for over 50 percent of auto sales. But that share is driven by government policies.

In the West, whenever governments reduce or eliminate EV subsidies, sales slow or fall. EVs remain expensive, charging networks are limited and often unaffordable, and range anxiety impacts buyer attitudes.

The IEA's forecast fails to address the impact lower oil prices will have on consumption. Petroleum products are needed for virtually every aspect of human life. That reality does not change in the world of EVs. Refineries can only reduce their gasoline output marginally, so in the IEA scenario surplus gasoline will be sold at low prices, undercutting the conversion of the global fleet from gasoline-powered vehicles.

Embracing financial discipline

Although current oil prices are below where producers would like them, they're less concerned than in the past. Since the 2014 oil price collapse, producers have embraced "financial discipline," shedding debt and limiting reinvestment in new supply initiatives.

Instead, they boosted dividends and stock buybacks. Producers have more levers to manage their cash flows in a low oil price environment. This flexibility explains record U.S. oil production and why it should remain high even in a lower oil price environment.

Years after he was ousted as petroleum minister, Yamani told an interviewer how he saw the oil market working. "Technology is the real enemy for OPEC," he said. "Technology will reduce consumption and increase production from areas outside OPEC."

Yamani remarked, "The Stone Age did not end because the world ran out of stone, and the Oil Age will end long before the world runs out of oil."

Are we approaching the Oil Age's end? No. Billions of people lack access to energy. They need oil products for better lives. That requirement will sustain the industry for years.