A new ceil­ing for oil prices

Financial Mirror (Cyprus) - - FRONT PAGE -

If one num­ber de­ter­mines the fate of the world econ­omy, it is the price of a bar­rel of oil. Ev­ery global re­ces­sion since 1970 has been pre­ceded by at least a dou­bling of the oil price, and ev­ery time the oil price has fallen by half and stayed down for six months or so, a ma­jor ac­cel­er­a­tion of global growth has fol­lowed.

Hav­ing fallen from $100 to $50, the oil price is now hov­er­ing at ex­actly this crit­i­cal level. So, should we ex­pect $50 to be the floor or the ceil­ing of the new trad­ing range for oil?

Most an­a­lysts still see $50 as a floor – or even a spring­board, be­cause po­si­tion­ing in the fu­tures mar­ket sug­gests ex­pec­ta­tions of a fairly quick re­bound to $70 or $80. But eco­nomics and his­tory sug­gest that to­day’s price should be viewed as a prob­a­ble ceil­ing for a much lower trad­ing range, which may stretch all the way down to­ward $20.

To see why, first con­sider the ide­o­log­i­cal irony at the heart of to­day’s en­ergy eco­nomics. The oil mar­ket has al­ways been marked by a strug­gle be­tween mo­nop­oly and com­pe­ti­tion. But what most Western com­men­ta­tors refuse to ac­knowl­edge is that the cham­pion of com­pe­ti­tion nowa­days is Saudi Ara­bia, while the free­dom-loving oil­men of Texas are pray­ing for OPEC to re­assert its mo­nop­oly power.

Now let’s turn to his­tory – specif­i­cally, the his­tory of in­fla­tion-ad­justed oil prices since 1974, when OPEC first emerged. That his­tory re­veals two dis­tinct pric­ing regimes. From 1974 to 1985, the US bench­mark oil price fluc­tu­ated be­tween $50 and $120 in to­day’s money. From 1986 to 2004, it ranged from $20 to $50 (apart from two brief aber­ra­tions after the 1990 in­va­sion of Kuwait and the 1998 Rus­sian de­val­u­a­tion). Fi­nally, from 2005 un­til 2014, oil again traded in the 1974-1985 range of roughly $50 to $120, apart from two very brief spikes dur­ing the 2008-09 fi­nan­cial cri­sis.

In other words, the trad­ing range of the past ten years was sim­i­lar to that of OPEC’s first decade, whereas the 19 years from 1986 to 2004 rep­re­sented a to­tally dif­fer­ent regime. It seems plau­si­ble that the dif­fer­ence be­tween th­ese two regimes can be ex­plained by the break­down of OPEC power in 1985, owing to North Sea and Alaskan oil de­vel­op­ment, caus­ing a shift from mo­nop­o­lis­tic to com­pet­i­tive pric­ing. This pe­riod ended in 2005, when surg­ing Chi­nese de­mand tem­po­rar­ily cre­ated a global oil short­age, al­low­ing OPEC’s price “dis­ci­pline” to be re­stored.

This record points to $50 as a pos­si­ble de­mar­ca­tion line be­tween the mo­nop­o­lis­tic and com­pet­i­tive regimes. And the eco­nomics of com­pet­i­tive mar­kets ver­sus mo­nop­oly pric­ing sug­gests why $50 will be a ceil­ing, not a floor.

In a com­pet­i­tive mar­ket, prices should equal mar­ginal costs. Sim­ply put, the price will re­flect the costs that an ef­fi­cient sup­plier must re­coup in pro­duc­ing the last bar­rel of oil re­quired to meet global de­mand. In a mo­nop­oly price regime, by con­trast, the mo­nop­o­list can choose a price well above mar­ginal costs and then re­strict pro­duc­tion to en­sure that sup­ply does not ex­ceed de­mand (which it oth­er­wise would be­cause of the ar­ti­fi­cially high price).

Un­til last sum­mer, oil op­er­ated un­der a mo­nop­oly price regime, be­cause Saudi Ara­bia be­came a “swing pro­ducer,” re­strict­ing sup­ply when­ever it ex­ceeded de­mand. But this regime cre­ated pow­er­ful in­cen­tives for other oil pro­duc­ers, es­pe­cially in the US and Canada, to ex­pand out­put sharply. De­spite fac­ing much higher pro­duc­tion costs, North Amer­i­can pro­duc­ers of shale oil and gas could make big prof­its, thanks to the Saudi price guar­an­tee.

The Saudis, how­ever, could main­tain high prices only by re­duc­ing their own out­put to make room in the global mar­ket for ever-in­creas­ing US pro­duc­tion. By last au­tumn, Saudi lead­ers ap­par­ently de­cided that this was a los­ing strat­egy – and they were right. Its log­i­cal con­clu­sion would have been Amer­ica’s emer­gence as the world’s top oil pro­ducer, while Saudi Ara­bia faded into in­signif­i­cance, not only as an oil ex­porter but also per­haps as a coun­try that the US felt obliged to de­fend.

The Mid­dle East’s oil po­ten­tates are now de­ter­mined to re­verse this loss of sta­tus, as their re­cent be­hav­iour in OPEC makes clear. But the only way for OPEC to re­store, or even pre­serve, its mar­ket share is by push­ing prices down to the point that US pro­duc­ers dras­ti­cally re­duce their out­put to bal­ance global sup­ply and de­mand. In short, the Saudis must stop be­ing a “swing pro­ducer” and in­stead force US frack­ers into this role.

Any eco­nomics text­book would rec­om­mend ex­actly this out­come. Shale oil is ex­pen­sive to ex­tract and should there­fore re­main in the ground un­til all of the world’s low-cost con­ven­tional oil­fields are pump­ing at max­i­mum out­put. More­over, shale pro­duc­tion can be cheaply turned on and off.

Com­pet­i­tive mar­ket con­di­tions would there­fore dic­tate that Saudi Ara­bia and other low-cost pro­duc­ers al­ways op­er­ate at full ca­pac­ity, while US frack­ers would ex­pe­ri­ence the boom-bust cy­cles typ­i­cal of com­mod­ity mar­kets, shut­ting down when global de­mand is weak or new low-cost sup­plies come on­stream from Iraq, Libya, Iran, or Rus­sia, and ramp­ing up pro­duc­tion only dur­ing global booms when oil de­mand is at a peak.

Un­der this com­pet­i­tive logic, the mar­ginal cost of US shale oil would be­come a ceil­ing for global oil prices, whereas the costs of rel­a­tively re­mote and mar­ginal con­ven­tional oil­fields in OPEC and Rus­sia would set a floor. As it hap­pens, es­ti­mates of shale-oil pro­duc­tion costs are mostly around $50, while mar­ginal con­ven­tional oil­fields gen­er­ally break even at around $20. Thus, the trad­ing range in the brave new world of com­pet­i­tive oil should be roughly $20 to $50.

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