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June 29, 2015

A Year of Lower Oil Prices: Crossing A Boundary

The oil price collapse of 2014-2015 began one year ago this month (Figure 1).  The world crossed a boundary in which prices are not only lower now but will probably remain lower for some time. It represents a phase change like when water turns into ice: the composition is the same as before but the physical state and governing laws are different.

Figure 1. Daily crude oil prices, June 2014-June 2015.  Source: EIA.
For oil prices, the phase change was caused mostly by the growth of a new source of supply from unconventional, expensive oil. Expensive oil made sense only because of the longest period ever of high oil prices in real dollars from late 2010 until mid-2014.

The phase change occurred also because of a profoundly weakened global economy and lower demand growth for oil. This followed the 2008 Financial Collapse and the preceding decades of reliance on debt to create economic expansion in a world approaching the limits of growth.
If the cause of the Financial Collapse was too much debt, the solution taken by central banks was more debt. This may have saved the world from an even worse crisis in 2008-2009 but it did not result in growing demand for oil and other commodities necessary for an expanding economy.

Monetary policies following the 2008 Collapse produced the longest period of sustained low interest rates in recent history. As a result, capital flowed into the development and over-production of marginally profitable unconventional oil because of high coupon yields compared with other investments.

The devaluation of the U.S. dollar following the 2008 Financial Collapse corresponded to a weak currency exchange rate and an increase in oil prices.  The fall in oil prices in mid-2014 coincided with monetary policies that strengthened the dollar.

Prolonged high oil prices caused demand destruction. This also allowed the expansion of renewable energy that could compete only at high energy costs. Concerns about global climate change and its relationship to burning oil and other fossil energy threatened the future interests of conventional oil-exporting countries. OPEC hopes to regain market share from expensive unconventional oil and renewable energy, and to renew demand for oil through several years of low oil prices.
OPEC increased production in mid-2014, and decided not to cut production at its November 2014 meeting   By January 2015 oil prices fell below $50 per barrel.

Most observers expected a sharp reduction in U.S. tight oil production after rig counts fell with lower prices. Production fell in early 2015 but recovered as new capital poured into North American E&P companies. This and the partial recovery of oil prices into the mid-$60 per barrel range gave expensive oil another day to survive and fight.

If capital continues to flow to unconventional oil companies and OPEC’s resolve stays firm, oil prices could average near the present range for many years. Oil prices will probably fall in the second half of 2015 as the ongoing production surplus and weak demand overcome the sentiment-based belief that a price recovery is already underway.

Oil prices must inevitably rise as unconventional production peaks over the next decade and oil-exporting countries increasingly consume more of their own oil. Politically driven supply interruptions will inevitably punctuate the emerging new reality with periods of higher prices.
For now, however, we have crossed a boundary and notions of normal or business-as-usual should be put aside.

A New Supply Source and Over-Production 
The main cause of the price collapse of 2014-2015 was over-production of oil.  Most of the increase came from unconventional production in the United States and Canada–tight oil, oil sands and deep-water oil. From 2008 to 2015, U.S. and Canadian production increased 7.65 million barrels per day (mmpbd). During the same period, non-OPEC production less the U.S. and Canada decreased 2.85 mmbpd and OPEC production increased 1.79 mmbpd (Figure 2).

OPEC-Non-OPEC-US & Canada_World Liquids Production Since 2008
Figure 2 . World liquids production since 2008 and the relative shares for the U.S. & Canada, OPEC and non-OPEC less the U.S. and Canada.
Source: EIA and Labyrinth Consulting Services, Inc.

North American unconventional and OPEC conventional production increased almost 4 mmbpd in 2014 alone (Figure 3).
U.S. + Canada and OPEC Liquids Production Since January 2014
Figure 3. U.S. + Canada & OPEC Liquids Production Since January 2014. Source: EIA and Labyrinth Consulting Services, Inc.

Through 2013, unconventional production growth was matched by decreases in OPEC production mostly from supply interruptions due to political events (Figure 4). The result was that prices remained high despite increases in unconventional production.

U.S. + Canada & OPEC Liquids Production Growth, 2011-2015         
Figure 4. U.S. + Canada & OPEC Liquids Production Growth, 2011-2015. Source: EIA and Labyrinth Consulting Services, Inc.

OPEC responded to defend its market share in mid-2014 by increasing production. Prices started falling in late June 2014 from $115 per barrel (Brent) and reached a low in late January 2015 of $47 per barrel after OPEC decided not to cut production at its November 2014 meeting.

Unconventional production slowed and fell in early 2015. Then, prices increased beginning in February and Brent has averaged $63 per barrel since May 1 (WTI average $59 per barrel). Over-production continues as different parties struggle for market share, for cash flow to survive, or both.

If high oil prices created the conditions for unconventional oil to grow and challenge OPEC’s market share, then prolonged low oil prices must be part of OPEC’s solution.  By keeping prices below the marginal cost of unconventional production (about $75 per barrel), OPEC hopes that expensive oil production will decline along with the fortunes of the companies engaged in these plays.

Decreased Demand and Demand Destruction 

OPEC is as concerned about long-term demand as it is about market share. Oil is the only major source of revenue for many OPEC countries and low demand, potential competition from other fuel sources, and the effect of a perceived link between oil use and climate change are existential threats.

Demand growth for oil has been declining since the late 1960s (Figure 5).  OPEC hopes to stimulate demand through low oil prices back to the peak levels that existed before the price shocks of the 1970s and 1980s.

World Liquids Demand Growth
Figure 5. World Liquids Demand Growth.  Source: BP, EIA and Labyrinth Consulting Services, Inc.

Demand destruction followed periods of high oil prices from 1979-1981 (Iran-Iraq War) and from 2007-2008 (demand growth from China).  2010-2014 was the longest period in history–33 months–of oil prices above $90 per barrel in real dollars (Figure 6). Since 2011, demand growth has fallen to only 0.5% per year so far in 2015 (Figure 5).

CPI WTI GT $90 26 March 2015
Figure 6. Crude oil prices more than $90 per barrel in 2015 dollars. Source: EIA, Federal Reserve Board and Labyrinth Consulting Services, Inc.

Prolonged low oil prices may restore growth to the global economy accomplishing what the central banks have failed to do since 2008. If successful, interest rates should rise and this may restrict the flow of capital to unconventional E&P companies. Most of the capital provided to these companies comes from high-yield (“junk”) corporate bond sales, preferred share offerings, and debt. In a zero-interest rate world (Figure 7), these provide yields that are are much higher than those found in more conventional investments like U.S. Treasury bonds or money market accounts. If interest rates increase with a stronger economy, capital may flow to more productive investments that offer yields that are more competitive with higher risk tight oil offerings.

Federal Funds Rate & CPI-Adjusted Oil & NG Price June 2015
Figure 7. Federal funds interest rates January 2000-June 2015 and Brent crude oil price.
Federal Reserve Board, EIA and Labyrinth Consulting Services, Inc.

Over-Production Continues

The over-production that began the oil price collapse continues and has gotten worse. The global production surplus (production minus consumption) has gone on for 17 months and has grown from 1.25 mmbpd in May 2014, just before prices began to fall, to almost 3 mmbpd in May 2015 (Figure 8).

World Liquids Production Surplus or Deficit & Brent Crude Oil Price_June 2015
Figure 8. World liquids production surplus or deficit and Brent crude oil price. Source: EIA and Labyrinth Consulting Services, Inc.

We may take some comfort that the rate of increase has slowed but it is difficult to explain the increase in prices over the last few months based on supply and demand.

The production supply surplus that is largely responsible for the current oil-price collapse is not a trivial event that will likely go away soon unless production is cut either by unconventional producers or OPEC. Earlier production surpluses in May 2005 and January 2012 were higher than today but were short-lived and related to specific non-systemic factors (Figure 9).

World Liquids Production Surplus or Deficit and Brent Price in 2015 Dollars
Figure 9.  World liquids relative production surplus or deficit and Brent price in 2015 dollars, 2003-2015. 
Source: EIA and Labyrinth Consulting Services, Inc.

The present supply imbalance is structural and persistent. The only comparable episode in recent history was the production deficit immediately before the 2008 Financial Collapse that lasted 11 months. It was driven by growing Chinese and other Far East demand and by dwindling oil supplies following the peak of conventional production in 2005.

For now, OPEC appears committed to continued over-production to achieve its goals. Its production increased 1.4 million barrels of liquids per day during the last year (Figure 3) and some analysts suggest it might increase by an equal amount again in coming months.

Meanwhile, U.S. production has not fallen much so far. Production from the main tight oil plays fell about 77,000 bpd in January 2015, was basically flat in February and increased 51,000 bpd in March (Figure 10). This is partly because companies are high-grading well completions in the best parts of the plays. It is also because of the backlog of drilled but uncompleted wells that are being brought on production at a fraction of the incremental cost of drilling new wells.

Tight Oil Play Prod & New Wells Added 13 June 2015
Figure 10. Oil production from tight oil plays in the U.S. Source: Drilling Info and Labyrinth Consulting Services, Inc.

But the most significant factor is that capital flow to U.S. unconventional plays has increased. Figure 11 shows that almost $17 billion in equity offerings flowed to U.S. oil companies in the first quarter of 2015, more than in any other period since 2010. The percent of E&P equity rose to over 10% of overall issuance from an average of about 4-5% over the last decade. This can only be explained because there are no alternative investments with comparable yields and that investors believe that they are buying assets that are somehow viable at current oil prices.

Q1 Funding for E&P from NOIA Presentation 17 June 2015
Figure 11. Capital available to U.S. E&P companies in the first quarter of 2015. Source: Wall Street Journal.

Tight oil companies have made the case that through increased efficiency and lower service costs that their economics are better at lower oil prices today than they were at $90 per barrel prices a few years ago. First quarter (Q1) financial results do not support this claim.
In fact, tight oil companies are losing more than twice as much money in Q1 2015 as they were in 2014. On average, companies that were spending $1.40 for every dollar they earned from operations last year are now spending $3.20 for every dollar earned (Figure 12).

Sampled E&Ps Q1 2015 vs 2014 Capex-CF June 2015
Figure 12. First quarter (Q1) 2015 vs. full-year 2014 capital expenditures-to-cash flow from operations ratio.
Source: Google Finance and Labyrinth Consulting Services, Inc.

Follow The Money

The strength of the U.S. dollar provides a simple and generally reliable way to cut through the complex factors that govern oil prices. A negative correlation exists between the strength of the U.S. dollar and the price of oil (Figure 13). This correlation is particularly strong beginning in about 1997.

CPI Adjusted Oil Prices & Federal Reserve Broad Dollar Index 25 June 2015
Figure 13.  U.S. Federal Reserve Board broad dollar index and CPI-adjusted Brent and WTI crude oil prices.
Source:  Federal Reserve Board, EIA and Labyrinth Consulting Services, Inc.

The relationship is key to understanding the current oil-price collapse. Figure 14 shows the daily exchange rate of the U.S. Dollar and the Euro in relation to Brent and WTI crude oil prices.  The onset of price decline coincided with a stronger U.S. dollar beginning in June 2014 that may be related to the end of quantitative easing and to an improving U.S. economy.  The recent increase in oil prices in 2015 corresponds to weakening of the dollar that may reflect disappointingly weak first quarter 2015 U.S. GDP growth.

USD-Euro Brent & WTI 2010-2015
Figure 14. U.S. dollar/Euro exchange rate, Brent and WTI prices. Source: EIA, Oanada and Labyrinth Consulting Services, Inc.

The standard explanation for the relationship between the dollar and oil price is that global oil transactions are carried out in U.S. dollars. When the dollar is weak against other currencies, oil prices are higher and when the dollar is strong, oil prices are lower. In other words, a stronger U.S. economy and currency may reduce oil prices and vice versa. While the observation is accurate, the explanation is more complex.

Oil and other commodities are hedges against economic risk and uncertainty. Oil prices increase and decrease as risk perception rises and falls. High oil-supply risk or “fear premiums” generally manifest as short-lived, upward price spikes that are quickly integrated into forward price expectations. Following the initial shock of oil-supply risk, U.S. Treasury bond and related “flight-to-safety” investments tend to lower oil price trends as the U.S. dollar appreciates.

Supply and demand balance operates as a first-order cycle against which economic uncertainty and geopolitical risk fluctuate as second- and third-order cycles. When a  first-order supply imbalance coincides with second- or third-order economic or geopolitical factors, an upward or downward price-cycle may develop. Higher energy costs are a weight on the economy that may lower currency values.  Conversely, lower energy costs may lift the economy and currency values.

The U.S. is the world’s largest economy and the U.S.dollar is the world reserve currency. This makes the U.S. dollar a fairly reliable reflection and measure of all of these factors.

The 2014-2015 oil price collapse may be understood then as a supply surplus that occurred at a time of a strengthening U.S. economy (low economic uncertainty) and relatively low geopolitical risk (Figure 15).  The additive effect of these three cycles was a sharp decline in oil prices.

World Liquids Relative Surplus or Deficit & WTI Price 2003-2015
Figure 15. World liquids production or surplus, Brent price and U.S. dollar index.
Source: EIA, Federal Reserve Board and Labyrinth Consulting Services, Inc.

Are Low Oil Prices Long or Short Term?

Oil price collapses in 1981-1986 and 2008-2009 are the only analogues for the present price situation (Figure 16). So far, the current price collapse seems more similar to 1981-1986 than to 2008-2009.

OPEC & Non-OPEC Oil Production, Consumption and Oil Price
Figure 16. The 1981-1986 and 2008-2009 oil price collapses in the context of OPEC andnon-OPEC oil  production, oil consumption and Brent crude oil price in 2014 U.S. dollars.
Source: BP, EIA and Labyrinth Consulting Services, Inc.

1981-1986 was a long-term event. The price collapse itself lasted for 5 years but oil prices remained below $90 per barrel in real dollars until 2007, almost 27 years.

2008-2009 was a short-term event. Prices began falling in July 2008 and reached a low point in December 2008. Prices recovered and reached $90 per barrel in April 2010 and $100 per barrel in March 2011. Then entire cycle from $90 per barrel and back again lasted a little more than 2 years.
The oil price collapse of the 1980s was similar to the present price collapse because the primary cause was a new source of supply. Non-OPEC production exceeded OPEC production in 1978 as new supply from the North Sea (U.K. and Norway), western Siberia (Russia), the Campeche Sound (Mexico) and China came on line. Unlike the present, the new supply was inexpensive conventional oil.

Oil prices had increased in 1979-1981 to more than $90 per barrel in real dollars because of supply interruptions at the beginning of the Iran-Iraq war. This caused approximately 4.3 mmbpd of demand destruction. Lower demand and continued supply growth from non-OPEC countries caused a production surplus beginning in 1982.

Oil prices fell from $106 per barrel in 1980 to $31 per barrel in 1986. OPEC cut 10 mmbpd of production between 1980 and 1985 with no effect on falling oil prices. In 1986, OPEC decided to increase production to protect market share, abandoning its role as “swing producer.”
Although neither the volume of new supply or the amount of demand destruction during the current price collapse are as great as 1981-1986, they are more similar than to 2008-2009.

The 2008-2009 oil price collapse was part of an overall crash of the entire global economy. High oil prices in 2007 and 2008 were due to a large and persistent production supply deficit because of high demand from China and the Far East, and dwindling supplies following the peak of conventional oil production in 2005 (Figures 15 and 17). The surplus had nothing to do with new supply but was completely due to decreased demand from a collapsing global economy. The surplus only lasted for 6 months and never approached the level seen in 2014-2015 (an OPEC production cut  in early 2009 limited the length of the surplus and possibly its magnitude).

World Liquids Relative Production Surplus or Deficit & Brent Price
Figure 17. World liquids production surplus of deficit (12-month moving average) and Brent oil price. Source: EIA and Labyrinth Consulting Services, Inc.

High oil prices preceding the 2014-2015 price collapse began because of supply interruptions resulting from the Arab Spring. Brent price reached a maximum of $129 per barrel in April 2011 at the height of the Libyan Civil War. These events corresponded with a period of U.S. currency devaluation following the 2008 Financial Collapse and an extraordinarily weak U.S. dollar (Figures 13 and 15). The additive effects of a supply deficit, economic uncertainty and geopolitical risk resulted in high oil prices.

Case histories neither predict the present or the future but offer guidelines. These two case histories simply suggest is that the present period of low oil prices is more similar to that of the 1980s and 1990s than to that of the 2008-2009 period. That similarity means that the current phenomenon is likely to be a relatively long-term event.


The availability of capital to fund unconventional production is the key to how long low oil prices will last going forward. If the flow of capital continues, then the production surplus and lower oil prices will also continue, assuming that OPEC is able to maintain higher production levels and that demand growth remains relatively low.

Eventually, price will win and unconventional production will fall. The market will rebalance and prices will rise. If oil prices stay low for long enough, demand will increase to support those higher prices. I doubt that prices will increase to levels before mid-2014 barring politically driven shock events. $90 per barrel appears to be the empirical threshold price above which demand destruction begins.

It is more difficult to predict how the second- and third-order effects of economic uncertainty and geopolitical risk may affect supply and demand fundamentals and, therefore, price.  These are the wild cards that could change the  outcome that I describe.

The most likely case is that oil prices will decrease in the second half of 2015 and that financial distress to all oil producers will increase. The hope and expectation that the worst is over will fade as the new reality of prolonged low oil prices is reluctantly accepted.

We have had a year of lower oil prices. Based on available data, I see no end in sight yet. The market must balance before things get better and prices improve. That can only happen if production falls and demand increases. That will take time.

We have crossed a boundary and things are different now.

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle

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