Friday, January 16, 2015

The World's Oil Market and How History Repeats Itself

Updated August 2015

As a petroleum geoscientist, I can quite clearly remember the downturns in the oil industry over the last three decades.  One of the worst occurred in 1986 when the price of oil very rapidly fell from $30.81 in November 1985 to $11.58 in July 1986.  The streets of many oil-centric cities in North America were awash with laid-off geoscientists, engineers and support staff, many of whom were never able to return to the industry that they had spent years in university training for.  From what we can see now, there are many parallels between what happened in 1986 and what is happening in today's oil market.

Here is a chart showing what happened to the price of oil in the years between 1982 and 1991:

Over the 9 months between November 1985 and July 1986, the price of oil fell by 62.4 percent.  While the price recovered to $21.36 in July 1987, it didn't retrace all of its losses until Saddam Hussein decided to invade Kuwait, an action that pushed the price up to $35.92 in October 1990 for a short period of time.  Basically, the price of oil remained at a depressed price for a full five years and would likely have remained depressed for a longer period had hostilities not broken out in the Middle East.

What caused the oil price collapse of 1986?  According to research by Dermot Gately at New York University, the 1986 price collapse was the direct result of a decision by Saudi Arabia and some of its OPEC counterparts to increase their share of the oil market by ramping up production.  Unlike today, by ramping up their oil production levels, the Saudis and their peers were able to avoid major revenue losses because the decline in oil prices were offset by increases in output.

It is interesting to look at what was happening to the demand for oil in the years leading up to the 1986 oil price decline as shown on this graph:

Oil demand increased fairly rapidly before the 1973 - 1974 price increase, grew less rapidly during the years from 1973 to 1978, then fell 10 percent during the years from 1979 to 1983 and rose only slightly from 1983 to 1985.  A series of recessions during the 1970s and early 1980s caused economic havoc in the world's economy, much of it related to oil price shocks during the 1970s which had a dampening effect on oil consumption rates.

Now, let's look at what was happening to the production of oil in the years leading up to 1986 as shown on this graph:

As you can clearly see, OPEC's share of the world's oil production had dropped significantly over the years between 1970 and 1985, falling by 40 percent between 1979 and 1982 alone.  This occurred largely because of increasing production from non-OPEC nations including Mexico, the United Kingdom and Norway (North Sea) and the Soviet Union and China.  During this timeframe, production from the United States actually fell by 7 percent between 1970 and 1985 and, without the impact of Alaskan oil, American oil output would have fallen by 25 percent over the fifteen year period.

When both supply and demand for oil in the mid-1980s are taken into consideration, it is clear that OPEC was forced to reduce its output to support prices as shown on this graph:

Between 1979 and 1985, each OPEC member country cut its output by at least 20 percent with Saudi Arabia and Kuwait each cutting their oil production by 60 percent and Libya cutting its oil production by almost 50 percent.

There are some key parallels between what happened in 1986 and what has happened to the world's oil markets over the past few weeks.:

1.) Growth in the demand for oil is levelling off and is likely to remain modest given the slowdown in China's economy and the near-recessionary economic growth levels in Europe.  

2.) Growth in the supply of non-OPEC oil is significant, thanks to the oil sands and tight oil.

3.) While Saudi Arabia has not increased production, it has decided not to cut production in the face of rising non-OPEC-sourced oil. 

While I am convinced that the world's oil supply-demand balance is very delicate and that the supply could swing quickly if both oil sands and tight oil production drops in the face of sub-economic prices and that the demand for oil could rise quite quickly if the entirety of the world's economy returns to a healthy state, there are significant parallels between what happened to the oil market in the years between 1985 and 1991 that suggest that we could be in for an extended period of depressed oil prices, particularly if we see a return to Great Recession-style economic contraction.


1 comment:

  1. When I lived and worked for Gulf Oil Corporation in Houston during the early '80s the running joke was "Who employed the largest numer of geologists in Texas?" The aswer: "JC Penney in the shoe department."