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Spikes and troughs

Only real supply-side intervention has stopped oil-price volatility. But those days are gone, argues Bob McNally's new book

If you need an example of a market best not left to the invisible hand, oil is it. Its price gyrations can destroy producers or hamstring consumer economies. And yet "extreme volatility… is an intrinsic feature of the oil industry," writes Bob McNally in a new book.*

Everyone wants price stability—the foundation on which to make investment decisions and plan economies. But the market, says McNally, president of the Rapidan Group and a former energy advisor to the White House, isn't about to yield it.

Forget the deal between Opec and non-Opec producers—Saudi Arabia's recent decision to cut oil output is not going to bring the prolonged period of calm everyone seeks. Since 2014, notes McNally, the kingdom has been adamant that it will not go alone, but only along with, supply reduction. And the response to the cuts from tight oil is already in: more supply.

This shouldn't be a surprise. The past 10 years, says McNally, show that the market has "been operating without a safety net". Opec and Saudi Arabia were unable to prevent the price surge of 2004-08, nor could they stop the collapse of mid-2014. An effective cartel does not react to booms and busts; it avoids them.

McNally says an "epic transition" took place in the market between 2008-14: "no swing producer was able or willing to regulate production to stabilise prices". In November 2014, when the kingdom decided—in the words of one advisor—"to take its hands off the tiller", things unravelled. We may conclude, writes McNally, "that the only thing worse than someone controlling the global oil market is no one doing so".

That's certainly the message that emerges from Crude Volatility. McNally has done his own historical price discovery, creating the most complete account of oil prices back to 1859 that I've seen. He tracked the volatility, comparing monthly price changes to create a clear picture of the market's troughs and peaks. It's the basis for his history of the sector—one of the best since Daniel Yergin's The Prize.

If you're a free-marketeer who accepts oil's strategic importance to economic growth, McNally's data lead to an uncomfortable thesis. The periods of lowest volatility were brought by the kind of market intervention decried by liberal Western governments. Monthly crude prices in the decades before Rockerfeller bounced up and down by 53%; but with the great man's firm hand applied, between 1879 and 1911, by just 25%.

Price stability came in what McNally calls the Texas era, starting in the mid-1930s and lasting until Opec's emergence in the early 1970s. This was the heyday first of the Texas Railroad Commission (TRC) and then of the Seven Sisters. Monthly prices moved by just 3.6% for decades.

Opec modelled itself on the TRC, and managed some success, keeping volatility to 24% for about 30 years until the price boom of 2004-08. This was thanks to Saudi Arabia's (and others') willingness during the oil crisis of 1979 to increase supply and, during the first half of the 1980s, repeatedly to cut production.

Swing producer no more

But this won't be repeated. The Saudi experience of the 1980s, when it officially assumed the role of swing producer, was punishing—and now hangs over its decisions. In the three years leading to August 1985, the kingdom slashed more than 6m b/d from its production. All the while, other Opec producers cheated on their quotas, North Sea output flourished, and demand failed to spark a revival. Saudi Arabia may have prevented an outright collapse in prices, but it wasn't able to stop their gradual deflation throughout that period. It reversed course in 1985, flooding the market. It has sworn ever since that it will never repeat the experience.

It also now lacks the ability to be a proper swing producer. That was evident, argues McNally, in 2008. As prices burst through Opec's agreed ceiling in the early 2000s and peaked above $145 a barrel in 2008, Saudi Arabia was powerless to act. It had run out of sufficient spare capacity—just as the TRC has run out of its excess capacity in 1972, writes McNally. That, he says, is when the TRC "lost control of the oil market for good".

Given today's structural oversupply, and considering Riyadh's fear of another 1980s nightmare, the kingdom seems unlikely to reclaim its swing-producer role, despite its reactive cuts to shore up prices now. Aramco would need to invest billions more dollars in spare capacity it may never use; and be called on to adjust supply in response to market conditions. Neither would enthral potential investors in an Aramco IPO.

Without the guiding hand, expect more volatility. This is dangerous. "Oil price gyrations destabilise producing countries … and can help trigger wars, revolutions and terrorism," McNally writes. The latest slough, which has killed off investment in oil that will eventually be needed, makes this vicious cycle even more difficult to stop.

McNally's book offers a warning. Histories of the oil industry aren't in short supply, but this is the pick of the recent bunch. If you're an investor in the sector, a policy-maker or diplomat, or you just want a heads up about the next threats facing the global economy, read it.

*Crude Volatility: The History and the Future of Boom-Bust Oil Prices (Columbia University Press, 2017)

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