Andreoli on Oil & Fuel: Another boom goes bust

History suggests that the current oil glut and the associated price decline will be a temporary phenomenon, and the economics and petro-physics of unconventional oil production—fracking in particular—further suggest that the domestic glut will be eroded sooner than most prognosticators believe. That said, forces outside the U.S. could cause the price slump to persist much longer than any shale oil producer is prepared.

On average, shale oil producers require oil prices to be $77 per barrel to break even on the investment, and only one of the 39 shale plays is profitable when prices are below $60. Not surprisingly, the recent price decline from nearly $100 per barrel in October to $50 in January has caused producers to rein in production activity.

The number of oil rigs drilling in the U.S. has declined 46 percent since October, and as a consequence, the EIA reports that production levels in April will be essentially unchanged from March.

Considering that over the last four years, production from these basins has increased at a compounded monthly rate of 2.4 percent, or an annual rate of approximately 33 percent, such a flattening of production represents a significant break from the trend. With low prices expected to persist, the rig count will to continue to fall, and domestic oil production will begin to decline sooner than later. On a month-over-month basis, domestic oil production will likely begin declining in May.

There is a caveat, however. Continued low prices will trigger a statewide tax break that will kick in for oil producers in North Dakota in June. This is important because approximately 825 wells have been drilled in the Bakken but have not been completed.

This means that the oil from these wells can be brought online in 30 days to 60 days. The tax break will likely inspire producers to bring these wells online regardless of where prices are at that point, thus offsetting the impact of the lower drilling rates.

From a historical perspective, what we’re witnessing in oil markets today can hardly be differentiated from the early years of the oil age when three major boom and bust cycles caused prices to fluctuate wildly between $10 per barrel and $110 per barrel in inflation adjusted terms.

In each of these three macro cycles, a new oil field was discovered, speculators rushed in and blanketed the land with wells, production skyrocketed, and fortunes were made. And in each cycle, the drilling mania caused a temporary glut, and as oil prices collapsed, many fortunes were lost.

These boom-bust cycles were broken in the early 1880s when Standard Oil came to monopolize the industry. The company’s founder, John D. Rockefeller, recognized that the benefit from gaining monopoly power was not realized through the extraction of predatory monopoly rents. The best use of monopoly power was to take the volatility out of the market, ensuring that consumers would purchase machinery and equipment and creating long-term demand for petroleum products.

With only one exception, Standard Oil was able to maintain a balance between supply and demand such that oil prices stayed within a narrow band between $18 per barrel and $22 per barrel. Following Standard Oil’s breakup in 1911, extreme volatility returned, with prices doubling by the end of the decade. By 1927, the government came to believe that production needed to be controlled by a force other than the free market, and the Texas Railroad Commission was given the power and responsibility to regulate oil production.

The Commission was able to restore price stability, and prices were maintained in a narrow price band between $15 per barrel and $20 per barrel for more than four decades—an impressive feat considering that the Great Depression and World War II both occurred in this period.

When U.S. production peaked in 1970, the Commission lost its ability to control prices because all of the fields that they had jurisdiction over were being produced at the maximum sustainable rate. Prices rose from approximately $10 per barrel to $50 per barrel by the end of 1973, when Saudi Arabia first wielded the “oil sword,” and they remained at that level until 1979, when the Iranian Revolution cut global oil production capacity causing prices to climb over $100 per barrel.

In response to rising oil prices, there was a rush of offshore oil development, which prior to the price increase was not economical. Of course offshore production had been occurring to some degree since the very beginning of the oil age, but until the mid-1970s deepwater production was stymied by both technology and price.

High oil prices during the 1970s also caused a significant contraction in consumption. And, just as demand was contracting, the rush offshore brought a significant amount of new oil into the market. Production gains were led by the U.K. and Norway, who targeted developments in the North Sea and the U.S., as fields in the Gulf of Mexico were rapidly developed.

As prices fell from the 1980 peak ($100 per barrel), OPEC cut production by an unprecedented 9.5 million barrels per day (36 percent). But even this was not enough to counter the surge in non-OPEC production and the contraction in consumption. Judging by OPEC’s reluctance to cut production to support higher prices today, it appears that they learned a lesson from history. Of course, the current reluctance probably has more to do with the geopolitical struggle between Saudi Arabia and Iran than with anything else.

Returning to the historical account, by 1986, prices had fallen to around $30 per barrel, and OPEC was forced to lift production. With OPEC back in the game, prices continued to fall, and were below $20 in 1998. The low price level sent pains through the industry, so much so that in March 1999, the cover page of The Economist read “Drowning in Oil.”

But just as high prices cut demand and caused oil producers to go on a drilling spree, low prices brought demand back just as producers cut exploration and production budgets. The result was that between 1998 and 2000, prices doubled, then doubled again by 2005, and again by 2008. Producers simply couldn’t keep pace with rising global demand.

In the same manner that high prices in the 1970s made offshore production feasible, and technological innovations made it possible, the price run that culminated in 2008 made unconventional shale oil production economical, and the technological advances—largely funded through federal grants—made fracking a viable option.

Producers rushed to the Bakken, Eagle Ford, Permian, and Niobrara basins. What happened next was, in a word, predictable. Domestic oil production, which was hovering at around 5.1 million barrels per day (mbd) in 2008, climbed to over 7.8 mbd by the end of 2013—an increase in excess of 50 percent. This strong domestic growth was, however, tempered by declining production elsewhere in the OECD, and strong growth in global demand. In total, after loosening in 2009 as the global financial crises eroded demand, markets had tightened significantly by the beginning of 2012, and remained tight through 2013.

Since January 2014, monthly production rates have surpassed consumption rates, and by October, it began to be apparent that oil storage had nowhere to go but up. The volume of commercial crude oil in storage had, up to that point, averaged 375 million barrels, with cyclical lows of 350 million barrels and peaks of 400 million barrels. Currently there are 450 million barrels in storage.

The current storage levels should be understood in context. Two forces are at work in addition to the simple mismatch between production and consumption.

First, the oil market is in a strong state of contango, meaning that futures contract prices increase significantly into the future. The expectation that oil prices will rise provides a strong incentive for owners of physical crude oil to refrain from selling product. So long as the cost of storage is less than the risk-adjusted rate of expected return, it makes little sense to push oil to a saturated market. Second, the largest refinery strike in the last 35 years has affected 12 domestic refineries that are responsible for one-fifth of the U.S. refining capacity.

Along with unscheduled refinery outages, the inefficiencies caused by the strike pushed refinery capacity utilization to decline more than usual.

Had refinery capacity utilization rates remained at 93.9 percent, as they were in the first week of January, the current glut would be reduced by 62.6 million barrels. And if this were the case, storage levels would be well within the normal range. As a consequence of the low level of capacity utilization, refined product markets have remained relatively tight even as crude oil prices have tanked. Since October, oil prices have declined 53 percent while diesel prices have declined only 22 percent. Had diesel prices followed oil prices, pump prices would be around $1.74 instead of $2.92.

Looking forward, low prices should continue to pull down drilling rates and domestic production should soon begin to decline, though the temporary tax bump in North Dakota may disrupt this. As refineries ramp back up, we should expect to see storage volumes decline somewhat.

Whether or not this translates to lower oil prices depends largely on factors outside of the U.S., and guessing, for instance, where Iran’s or Libya’s export volumes will be in six months will be just that—a guess.

In an era where there is no Rockefeller, no Texas Railroad Commission, and OPEC is either helpless or complacent, volatility will rule oil markets. If history provides any clues to the future, we should expect a strong price recovery at some point, and the magnitude of the bounce depends on just how low prices go, and how long they stay low.