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More boom, more bust for oil

The industry's history suggests that Opec’s latest efforts to stabilise the oil price will not be successful

The latest oil-market narrative holds that in late 2014 Opec embarked on a new strategy that prioritised market share over high (and stable) oil prices, based on the view that high-cost and capital intensive US shale would be forced to swing under a glutted market. Instead, shale persevered, inventories swelled, and crude prices crashed, prompting Opec to resume the mantle of supply manager late last year. This narrative, and Saudi Arabia's newfound willingness to manage markets, underpins prevailing forecasts showing stable prices around $60 per barrel for the foreseeable future.

But my view, informed partly by historical research undertaken for my recently published book, Crude Volatility: The History and the Future of Boom-Bust Oil Prices, suggests a different narrative: Opec went AWOL 10 years ago when it proved unable to cap the price boom, not two years ago when it declined to prevent a price bust. Notwithstanding recent pledges by some Opec and Non-Opec producers to restrain production, it is far from obvious the market has an effective swing producer or that future oil prices will be stable.

The extreme gyrations seen over the past decade—with prices tripling between 2004 and 2007, crashing in 2008, recovering and crashing again (by nearly 80% from the mid-2014 peak to the early 2016 trough)—are not examples of conventional oil-price volatility. The usual suspects were conspicuously absent: no embargo, war, or other disruptions caused the boom, and no recession caused the latest bust. This strain of volatility was last seen over 90 years ago and reveals something we've forgotten—how volatile oil prices can be when a structurally unbalanced market needs a swing producer but does not have one.

Since oil's first days in western Pennsylvania 158 years ago, boom-bust price cycles have vexed the industry. To stabilise prices, companies tried with varying degrees of success to limit wellhead supply. John D Rockefeller's Standard Oil went first, exerting indirect control by monopolising the refining sector from about 1880 to 1911. Standard Oil's break up was followed by two turbulent decades of boom-bust prices until the Texas Railroad Commission (and other oil states), along with the Seven Sisters in the Middle East, imposed strict production controls. Their effectiveness can be seen, using a new monthly historical oil price series developed for my book.

Opec's founders tried to emulate the Texas Railroad Commission, but enjoy neither its market dominance nor cohesion. The group's high point was in the early 1980s, when Saudi Arabia last played the role of swing producer amid a massive market weakening by slashing production from 10m to 2m barrels a day. But Riyadh grew tired of surrendering market share in 1986 and crushed prices with a sudden and dramatic reversal. Since then, the kingdom has been less a swing producer and more leader in collective cuts, usually following price swoons.

Brisk GDP growth and soaring Chinese demand 10 years ago, along with sticky non-Opec supply, called out for a swing producer able to cap runaway prices. The quintupling of oil prices in the mid-2000s exposed Riyadh's inability to do so (Saudi Arabia, like the Texas Railroad Commission in 1972, had run out of spare capacity in peacetime.) Then, in 2014, shale's emergence required years of sustained production cuts to keep prices stable around $95/b. But Riyadh proved unwilling to play the swing producer role it abdicated in 1986.

Price slump

After crude crashed to $26/b in February 2016, Saudi Arabia changed its tune. For the better part of last year Riyadh, other Opec producers, and Russia were remarkably successful at influencing traders' perceptions by jawboning about a "freeze" in output. From January to October 2016 they talked up prices while adding a net 1.4m b/d to a glutted market. Collective cuts, mainly by Saudi Arabia after hitting a record production peak, implemented in January, may precede imminent and massive stock draws as the consensus expects, though the jury is still out and recent inventory and price data suggest grounds for skepticism.

In any event, it would be premature—at best—to view recent collective pledges as the return of an effective supply manager. From oil's earliest days, crude price busts prompted terrified producers to form ad hoc, temporary and "emergency" cartels (the first was the Oil Creek Association in 1861 which lasted a few months). These emergency cartels occasionally enjoyed success, but invariably failed due to supply growth outside and cheating within.

It is possible, but unlikely, that oil supply and demand will naturally balance in the coming decades, keeping prices generally stable. More likely, the market will deal us upheaval, disruption and imbalances. Moreover, price booms and busts themselves contribute imbalances between production and consumption. Saudi Arabia remains willing to lead in collective emergency cuts following busts, but is neither able nor willing to play the genuine swing-producer role required to prevent booms and busts in the first place. Saudi oil minister Khalid al-Falih made it perfectly clear that Opec would no longer adjust supply in response to structural imbalances in his televised dialogue with Daniel Yergin at the CERAWeek conference in March. Shale is more flexible than conventional supply, but not nearly nimble enough to play the role of global supply balancer.

While shale remains a new phenomenon, the evidence so far suggests it is flexible enough to contribute to price-busting oversupply but not flexible enough to put a floor under prices. Whether shale will prove better at capping the upside when the next boom phase kicks in remains to be seen; I am skeptical. Expect temporary periods of calm prices as seen between 2010 and 2013. But buckle up for more of the wild, unexpected price swings of the sort seen over the past ten years. Welcome back to boom-bust.

Bob McNally is president of The Rapidan Group and author of a new book, Crude Volatility: The History and the Future of Boom-Bust Oil Prices (Columbia University Press, 2016)

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