Oil Recoil: Overdone?

Rocked by the oil price shock? Wild swings in black gold aren’t that uncommon if you’ve been around for awhile. I recall having intense conversations about the planet running out of oil back in the ‘70’s – when I was in elementary school. It’s not that I was some bespectacled wunderkind – actually, at the time it was a common topic at that level; such was the state of global concern. Since then, there have been a few hair-raising price swings, most of which persisted for a number of years. Will the current price plunge be with us for some time, or is it temporary?

The recent history of volatility goes back to the 1970’s. The period of relatively stable post-war prices was interrupted by OPEC production cuts that triggered big upward movements and speculation of short global supplies. Higher prices spurred a lot of non-OPEC investment, and by the mid-1980’s, fears of global oil drying up were a joke. Prices plunged in 1986 and remained in the $20 per barrel range for 16 years.

The under-investment that ensued bumped into emerging market thirst for crude, and a demand-driven escalation began in 2003, culminating in the great price spike of 2008. Global recession – likely aided by that spike – took prices from triple digits down to $35 per barrel inside the year. This time, the plunge didn’t persist. Fears of thin supplies re-booted prices, and they were quickly back to triple-digits. Against fears that recovery would move the needle even higher, the opposite happened. US recovery has actually coincided with a dramatic plunge that is still looking for its absolute bottom. With all our experience of ups and downs, analysts are still trying to get a grip on reasons.

As in the past, the recent period of persistent high prices led to considerable new investments in the patch. In fact, it was one of just a few areas where investments were exciting over the past 7-8 years. With the expectation of high and rising prices forever, higher-cost oil was discovered in some unlikely places, and non-conventional sources that were previously unreachable or un-economic ended up flooding the market. At the same time, technology did not stand still – methods were developed that reduced the cost of those more exotic supplies. It’s a classic story, proving the dynamics of demand and supply – even for non-renewable resources like oil. It’s why, with all the demands of today’s economy, supply is once again in great excess – against famous predictions, we’re not running out of the stuff anytime soon.

But stopping the argument here could lead us to repeat the error. Now, analysts are getting the world ready for a protracted period of low prices, and many are using today’s price of around $30 as a launching point. Are they right? While prices are not likely to get back to triple digits anytime soon, barring a nasty geopolitical development, today’s prices aren’t likely the norm for the next number of years. First, we are still in the throes of the Fed’s interest rate hike, and the bears are shorting a lot of things out there, including oil. Second, growth is spurring a reallocation of investment –sectors that were not attracting funds are now back in the picture, and the money is making its way there. Third, low prices create a shift in demand that isn’t ever present right up-front. As expectations shift to a low-oil-price world, cheaper prices encourage higher usage, switching from other energy sources and investments predicated on revamped, low-price business models.

The nations that are most likely to spur this new investment are the heavy net importers of crude oil. They are now buying at a deep discount to previous expectations, and the bonus to their economies is obvious at the gas pumps and elsewhere. Savings accruing to the EU were almost $170 billion last year. America received a $140 billion bonus. China, India and others were also great beneficiaries. Given today’s prices, these bonuses will only be augmented this year. And as this activity sets in, higher usage will lead to a recalibration of supply-demand balances, and prices should get some near-term lift.

The bottom line?

The oil price rout still has the world in shock. As in the past, the extreme view is the popular one. But as in the past, the fad will fade, and as reality sets in, so too will relief to an oil patch in recoil, and a world that’s convinced it’s all about a frail economy. The coming months will tell the tale.

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