Tuesday, 16 December 2014

Reason for Crude Oil Price Decline

When I first heard about OPEC, which is an oil cartel, I was in my 20s and thought to myself, "How can the world let such an organisation exist? Would it mean that they have the power to fix prices of crude oil?"

My naive response was that OPEC could simply decide as high an oil price as they could in order to maximum profit. After all, why wouldn't anyone want to sell at a higher price for the same amount of their finite commodity?

10 year crude oil price chart between 2004 to 2014
10 year crude oil price chart (click to enlarge)
Source: nasdaq.com

Of course, it isn't that simple. As the world's economy is so heavily dependent an oil, a high oil price will dampen the world's economy, and thus will lower their demand and ultimately the price of oil. A crude price reaching the moon will kill the world economy, just as we have seen in 2008 where the crude spiked to an unsustainable level in a relatively brief period between start of 2007 to early 2008.

The world's economy didn't collapse in 2008 due to the exorbitant high crude price, but it didn't help. This unsustainable crude price in 2008 was all part of an asset speculative bubble. If the crude continued to climb higher in 2008, even if the sub-prime fiasco didn't crash the world's economy, the high oil prices will if it sustained at the peak level or higher for awhile.

World's average GDP between 2005 and 2015
World's average GDP and trade growth between 2005 and 2015 (click to enlarge)
Source:  WTO Secretariat.

Let's look at the two 3-year periods that preceding and succeeding the Great Recession of 2008. The first period is between 2004 to 2007, and the second is between 2011 to June 2014.

In the first period in question, the world economy was booming; in the second period, American economic had an anemic growth rate, Europe still had not out of the woods, and even Chinese economy was prodding at relatively slower pace. The graph above tells this story.

And yet, the bottom of the price of crude oil in the second period was higher than the top of the first period. In fact, it has been steadily rising. People was talking that this higher level of crude price as the "new normal". This "new normal" of high crude prices provided the impetus for the shale oil industry to shift itself into higher gear.

Crude price has to be at least well over $80 - 100 to make shale oil industry sustainable. And if the impression that the new normal is over $80, this is the opportunity that the shale oil industry has been waiting for.

But nobody asks OPEC if they accept this new normal. Initially, they would be happy with the new normal of high prices that helped them to rake in higher revenues. But higher crude prices also introduce new alternative players to crude oil industry. In this case, shale oil industry.

Very high prices of crude always bring on new innovations. Following the Energy Crisis in 1979, fuel efficiencies in cars improved in leaps and bounds. A few decades later, the fuel efficiency drive stopped as price of crude dropped significantly and the fear of such Energy Crisis subsided. This time, higher price of crude spurs the shale oil industry.

If OPEC wants to price their competitors - the shale oil industry - out of business, they have to drive their crude price lower for extended period until the whole shale oil industry is collapsed. OPEC tries to nip this industry in the bud.

How low and how long can the oil price go? As low and as long as it takes.

Bit the dust by low crude oil
After 5 months of continuous lowering of crude prices, last week OPEC claimed victory over its first loser in Western Australia. Red Fork Energy - an Australian shale oil company - is in receivership. You can read the article here. Is this the fall of the 1st domino? Time will tell.

I don't buy the assertion in the linked article above that

"That's because OPEC needs a $100 a barrel just to keep the public servants employed because the revenues to run these countries largely come from royalties and taxes from production of oil."

This is because except for the brief period during the Energy Crisis when the price of oil touched just a tad above $70/barrel, the price of oil never reached above $70 before 2007 since the late 19th century !

Price of oil since 1970
(click to enlarge)

The speculative run-up in 2007 is, well a pure speculative bubble. So the relative high price of oil  in the last 5 years is an anomaly from a historical stand point. Far from normal. This is probably due to the instability in the Middle East (Egypt, Libya, Iraq, Syria, ISIL).

So why do they suddenly just in the last few years require $100/barrel to pay for the public servants? How did they pay for the public servants in the previous 100 years? The average crude oil price over the last 100 years is around $45/barrel.

My naive concern about OPEC raising prices to benefit themselves had been misguided. For the first time, they want lower crude prices to benefit themselves. At least in the long run, in the short term, low prices are hurting themselves and the oil industry.

But the oil industry isn't complaining because what OPEC doing is pricing out their potential competitors for them. Neither are the motorists complaining about the lowering of prices. Least complain of all is the airline industry. Their share prices are soaring into stratosphere.

Some win, some lose.

Share price of Qantas - an Australian national carrier.
This price actions is typical of most airline companies
Source: Bloomberg

The shale oil industry is keeping the crude at reasonable prices until the oil runs out or until the shale oil industry can lower the cost of shale oil production even lower in the future with new scientific discoveries and technological innovations.

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