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Re: Oil Markets Revisited



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Regarding the oil-price collapse I referenced yesterday, a reader cautions against complacency:

I think it is important to note the likelihood for a giant rebound for oil and natural gas prices once the global economy recovers.  The current credit crisis and significant reduction in commodity prices has greatly impacted the capital spending plans for the entire industry.  The drilling rig count in the US has dropped by more than 60% according to Baker Hughes in the past 7 months.  These operations can not be instantly restarted when the demand returns.  Thus, we could face a situation 2-3 years from now where when the global demand for oil and gas returns to 2008 levels, the oil and gas industry could possibly fail to deliver due to sagging investment.  This will not only be felt in the US.

Well, anything is possible, but oil-price forecasts are for fools or charlatans. Hence, I will not offer any predictions. 

That said, oil markets have historically been characterized by rather long-playing boom-and-bust cycles, a natural consequence of the fact that both consumers and producers respond rather glacially to changes in supply and demand. 

There have been seven such boom-and-bust cycles in oil markets:

    – The first price spiral culminated in a peak price in 1876 only to be followed by a subsequent price collapse that ended in 1892;
    – The second price spiral began in 1892, reached a peak in 1900, and was followed by a subsequent price collapse that hit a low-point in 1910;
    – The third price spiral began in 1910, reached a peak in 1920, and collapsed again to a low-point in 1931;
    – The fourth price spiral began in 1931, reached a peak in 1937, and the subsequent collapse didn’t hit its lowest point until 1946;
    – The fifth price spiral began in 1946, reached a peak in 1957, and collapsed again until prices hit their lowest point in 1972;
    – The sixth price spiral began in 1972, hit a peak in 1981, and began to decline thereafter until a low-point was reached in 1998;
    – The seventh price spiral began in 1998, hit a peak in 2008, and … who knows?

    It’s interesting to note that domestic wellhead prices did not hit a trough after a peak prices were reached for 16, 10, 11, 9, 15, and 17 years respectively during previous boom-and-bust cycles. Hence, if 2008 turns out to be the year in which a peak price was reached during this particular price cycle — and past indeed proves to be prologue — prices will continue to decline over the next 13 years (give or take a few) before oil prices begin to march back up again. 

    Those arguing that oil prices may begin that upward march sometime this year or next — or, at the very least, when the economy moves into recovery — are predicting something that we’ve literally never seen before. While one can make a case that structural changes in the oil market have occurred this time around, which explains a likely break in trend (namely, the emergence of China, India, and other lesser-developed nations as major oil consumers and perhaps a peak in non-OPEC oil supply), I am always skeptical of claims that “this time, it’s different.” Sometimes it is, but more often that not when it comes to markets, it isn’t. We’ve heard “this time, it’s different” claims during each and every one of the previous oil price cycles . . . and each time, those claims have proven wrong.

    The second interesting thing to note about these boom-and-bust cycles is that prices always retreat to about the same place after a price shock is completely played out, somewhere between $10-20 a barrel in today’s currency. Hence, if past is prologue, oil prices still have a long way to fall before they begin their march again back up again. 

    Finally, there is no secular increase in oil prices over the course of the historical record. Oil markets boom and bust, but there is no gradual increase in average prices (yet).

    So while it’s certainly possible that we’ve only earned a short-term breather when it comes to oil prices, I wouldn’t bet on it.     



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