Why it's feeling a lot like 1986 in the oil markets
The year was 1986. Nintendo had just released Super Mario Bros., one of the best selling video games in history. Prince Charles and Princess Diana inaugurated Expo 86, propelling Vancouver to the world's stage. And gas prices were in free-fall, much to the delight of drivers everywhere.
The collapse of oil prices in the mid-80s came after the big energy crisis of the 1970s. The 70s was a decade marred by war, conflict, military coups and civil unrest. In 1973, OPEC declared an oil embargo and blocked crude oil shipments to the West in response to their defence of Israel during the Yom Kippur War. Crude oil prices shot up 400% overnight. The oil price shock came at a time when US oil production was declining but oil consumption was sharply on the rise.
Most industrialized countries suffered through painful recessions brought on by high oil prices. But the price shock also spurred a number of important changes in the way oil was consumed. The sale of Detroit-built gas-guzzling automobiles began to decline in favour of more compact Japanese imports. The burning of oil for electricity fell out of favour, replaced instead by coal, nuclear and natural gas.
Lofty oil prices also spurred more exploration. Alaska, the North Sea, Siberia and the Caspian Basin were suddenly economically viable. The former Soviet Union quickly became the world’s largest oil producer. After bottoming in 1982, world oil supply began to increase sharply. The world was awash in oil when prices suddenly collapsed by 60% in 1986. Saudi Arabia responded by drastically cutting production to just 3.8 million barrels per day (from its usual 10 million bpd only a few months prior) but oil prices didn't respond. The other OPEC members all cheated on their quotas and cranked up production to compensate for the loss of revenue brought on by lower prices. The Saudis lost market share to Russia, Mexico and the US, which were all increasing oil supply. OPEC suddenly lost its dominance over the oil markets. With exception of the Gulf War spike in 1991, oil prices were destined to remain range-bound between $11 and $25 a barrel for the next 14 years.
Does any of this sound familiar?
There are many parallels being drawn between the current energy slump and the prolonged weakness in oil prices which began in 1986. Both downturns were caused by too much supply and not enough demand. The Asian crisis of the late 80s and the worldwide economic recession of the early 90s stunted global growth. The lack of investment in energy infrastructure, however, didn't impact oil supply until the year 2000, when production finally began to decline meaningfully.
WHY IT'S DIFFERENT THIS TIME
Although there are a lot of similarities, there are a few very important differences this time around . . .
Interest rates are at historic lows
Interest rates were at historic highs in the mid-80s. Inflation peaked at 12% in 1980. A highly indebted oil company couldn't survive very long when oil prices fell. That isn't the case today. Interest rates are at historic lows. Even companies with a very poor debt rating can easily and cheaply raise funds in the capital markets. And that means it might be a while before the highest cost producers decide to shutdown, restructure or get taken over.
Exploration and extraction technology has significantly improved
Hydraulic fracturing has revolutionized the oil industry. US shale production can quickly switch on when prices rise and just as easily switch off when prices fall. And exploring for oil has never been easier. An offshore oil platform or oil sands mine takes billions of dollars and decades to plan, construct, commission and bring online. But a horizontal well only takes a few million and a few months to begin producing oil. Lower risk and less barrier to entry. The recent step change in oil extraction technology will make it more difficult for prices to recover meaningfully.
Plenty of oil is waiting for the chance to return to market
Libya and Iran are prime examples of big energy players that are producing only a fraction of their capacity. That production is just waiting for the opportunity to come back into the market, no matter what the oil price. Countries like Venezuela, Mexico and even Canada to some extent have the capacity to significantly increase oil production if the government suddenly comes up with the political will. Peak Oil is officially dead. There is plenty of oil out there, ready to come online at the right price. And that's likely why all the geopolitical risk has come out of the energy markets.
WHAT WILL IT TAKE FOR PRICES TO RECOVER BACK TO $100?
There's one thing we know for sure - this won't be a 2009-style V-shaped recovery everyone was hoping for. The 2008/09 price drop was demand-driven, which is much easier to fix. A collapse of financial markets in 2008 was "mitigated" with a flood of government spending and Quantitative Easing (or bond buying). Trillions of new money was poured into the world economy, which temporarily reflated demand for commodities and perked up oil prices. But that was before the US shale boom. This collapse is supply-driven, much like the 1986 price drop, which takes much longer to fix.
If history is used as a guide, it's very likely we'll be stuck in the $40 to $60 range for quite some time. Downswings tend to last longer than the upswing, or at least they have for the past hundred years.
Demand isn't the problem
The spectacular growth of emerging markets, particularly China, which began in 2004 was the main driver behind the last oil boom. China still only has 1/5th the car-ownership rate of a developed nation, so there's plenty of room for growing oil demand, albeit not as fast as was hoped for. Right now, world oil demand is expected to grow by 1.3 million barrels per day next year - not bad, but not great. The threat of a global recession in emerging markets next year would really put a dent in the oil demand curve. But right now, nobody thinks demand is the problem.
The US may not blink first
Goldman Sachs estimates the oil market is currently oversupplied by 2 million barrels per day. By comparison, US shale contributes almost 5 million barrels per day to the global oil market. Although oil production from the Bakken and Eagle Ford basins have been slowing, production from the Permian Basin has been rising. And why wouldn't it? Shale oil producers can turn a small profit at $40 a barrel, and they're working hard to drive those costs lower. That's why US shale producers might actually survive low oil prices better than anyone else.
Saudi Arabia learned its lesson the hard way in the 80s
Saudi Arabia produced a record 10.56 million barrels per day in July and has a record number of oil rigs in the field. Surprised? You shouldn't be. The experience of the 1980s has taught them that defending your market share is far more important than trying to control the oil price, which likely won't work anyway. So don't count on OPEC to cut production.
Lots of new production is still coming online
Trillions have been invested in the past 10 years to bring new production online, and that production isn't going to stop anytime soon. New production from offshore mega-platforms and oil sands mining operations continues to come online every day, adding to the already oversupplied energy markets. Offshore oil platforms can run for several decades before needing to be decommissioned. Oil sands mining operations can run for 30 to 40 years before the ore is exhausted. This new oil production isn't going away until the reserve is depleted or the operation runs at a loss for a considerable amount time.
There's still plenty of oil to be found
Shell is still drilling for oil in the Arctic. Exxon and Venezuela are still bickering over a massive (and untapped) deposit recently discovered off the coast of Guyana. There's still plenty of oil to be found for those with pockets deep enough to keep looking. What needs to happen is a depletion of existing production, particularly offshore and conventional. Canadian conventional oil production is already on the decline, but the same needs to start happening everywhere else in the world.
So how long until we're back to $100 oil? Barring a significant contraction of Canadian or US oil production or a military coup in Saudi Arabia, we're guessing probably not until the middle of the next decade. The best advice for any energy producer at this point is to lower costs, improve operating efficiencies, hunker down and wait for the next oil supercycle.