HOUSTON—Three prominent economists, armed with reams of data and decades of observations, assessed the causes and outlook for crude price volatility before a packed house at the recent KPMG Global Energy Conference.
Conclusion: “Oil has become the new corn.”
Not what you were expecting? Hey, the Saudis don’t care for it either, but the data provide strong support.
“Oil is going to be much more like an agricultural product, meaning when there are disruptions to supply like the fires in Alberta, or the MEND [Movement for the Emancipation of the Niger Delta] attacks in Nigeria, supplies will get cut, prices will go up,” said Philip K. Verleger Jr., who served in the Ford and Carter administrations and later played a key role in creating oil futures markets. “But then there will be periods when there are huge crops and you’ll see prices go down.”
If that appears to contradict what has long been accepted about the economic fundamentals of the oil business, that’s because it does.
The mindset was defined by Harold Hotelling, an economist whose paper, “The Economics of Exhaustible Resources,” was published by the University of Chicago Press in 1931. Hotelling’s theory was that producers of nonrenewable resources like oil will only produce a limited supply of their product if it generates more profit than bonds or interest-bearing financial instruments.
Therefore, long-term prices will rise year after year at the prevailing interest rate—in theory.
But two years ago, the leaders of Saudi Arabia found themselves in an existential crisis. They looked at the steps being taken to combat global warming. They saw the success of unconventional techniques in the U.S. like horizontal drilling and hydraulic fracturing, and concluded that, long term, their oil was going to be left in the ground, Verleger said.
“What this does for those of us who study resources was essentially turning Hotelling upside down,” he said.
So much for “peak oil.” In this situation, oil as a natural resource is no longer finite, and it put the Saudis in a race with other producers, particularly Venezuela, to pump as much as possible for as long as possible until the market disappeared.
Twenty years ago, Venezuela had the upper hand and sought to push Saudi Arabia out of the market. Times have changed and now the Saudis are trying to return the favor.
“They are pushing for maximum production,” Verleger said. “I think they’ll probably try to go for 13 million or 14 million barrels per day [bbl/d] and I don’t think that they will ease off.”
But it’s not just Saudi production that is fueling glum times. Global energy companies have issued about $400 billion a year of debt since 2014, despite falling prices.
“One thing we know from economics is that when you have oversupply of something and you have leverage on the back end that is linked to that oversupply, your trough tends to be longer,” said Constance Hunter, KPMG’s chief U.S. economist. “It’s a situation where it’s possible—now, of course oil prices are notoriously difficult to predict—it’s possible that this downturn could be a little lower and a little longer than a lot of people have anticipated. And yet, for non-economists looking at this, look at the open interest in the oil contracts. It still remains pretty high.”
On June 7, oil closed at $50.41 a barrel on the New York Mercantile Exchange. That’s good, right?
“The most dangerous assumption in economics is when people come to believe this time is different,” said Mustafa Mohatarem, chief economist for General Motors Co. “It isn’t. So it’s a question of, where will the new demand come from that absorbs the new capacity that we’ve brought to the market?”
Mohatarem acknowledged how the current relatively high prices may distort this view, but he noted that in previous eras, oil price stability were maintained first by the Texas Railroad Commission beginning in the 1930s and later by OPEC in the 1970s.
“Absent the cartel, absent the price regulation, you will always have a price crash coming,” he said. “The problem is, that in itself sets in motion the process of people seeking new resources or new technologies and that again brings the price down.”
Joseph Markman can be reached at jmarkman@hartenergy.com and @JHMarkman.