Crude Volatility - Robert McNally

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High level summary

  • Oil is unsuited to cartelization and thus the price of it is bound to be volatile

    • Inelastic supply and demand, AKA price stickiness, means that it is not responsive to moderate price changes -> huge swings -> self-reinforced by traditional (shale oil is different) cost structures and recovery periods of producing

      • E.g. when 3% of global supply went offline in 1979 (Iran), prices went up by 126%
  • John D. Rockefeller’s(1870s -1910s) successful horizontal integration of pipelines and refineries offered some price stability (half the volatility of preceding period)
  • Another era of price stability occurred when Oklahoma Corporation Commission (OCC) and the Texas Railroad Commission (TRC) managed to successfully control their states’ production figures and therefore domestic prices, while the ‘Seven Sisters’, seven MNCs that controlled 85% of the world’s oil reserves pre-1973 colluded to keep international prices high
  • Spare capacity of production is a valuable national security asset
  • Back to price volatility post-1973, the “OPEC-era,” due to OPEC’s inability to cooperate and properly manage supply
  • Since ~2007, a new era of boom-bust has returned, due to shale oil and Saudi Arabian oil policy
    • Shale oil production (fast decline) and cost structures (expensive to drill, but cheap to operate), and its decentralized nature offer little opportunity for output/price stability
    • Saudi Arabia has historically acted as the swing producer, i.e. the figure in OPEC that would reduce output to maintain price stability… in recent years she’s abandoned this role because production cuts would cede market share to Iran/Iraq

 

Crude Volatility is a timely book that places oil in its historical context, as an inherently volatile commodity that producers have attempted to tame in vain for centuries, and that explains recent oil price movements as both a return to the status quo and a consequence of two key factors: US shale oil and Saudi Arabian oil policy. McNally, a former top energy advisor at the White House, traces oil’s history back to its humble beginnings (though not in a manner as comprehensive or with as powerful a narrative as Daniel Yergin’s 912-page epic The Prize – still considered a must-read for anyone seeking real insight into history of the oil industry) in 1858 when the US burned 500x more whale oil than crude.

After Drake’s initial discovery in Pennsylvania in ‘59, a frenzy for oil began, exacerbated by the law of “rule of capture,” which held that the owner of surface property owned any resources collected from his property, regardless of whether or not they migrated from someone else’s adjacent property. Thus the first landowner to capture the natural resource won ownership rights. Because entering the drilling industry was cheap and easy (in those days at least), supply would inevitably race ahead of demand, triggering price crashes, which in turn produced the boom-bust cycles in oil prices, that would come to characterize oil.

Early on, producers tried to mitigate this issue by forming cartels, groups of competing firms that by coordinating, would restrict production and thus raise prices. Though cartels tend to develop when (1) demand for a product is steady, (2) the product is standardized, and (3) capital or transportation costs are heavy relative to operating costs such that firms cannot respond quickly to changing conditions —conditions which oil satisfies – they perform best when (1) there are a limited number of producers, (2) barriers to entry are high, and (3) patented technology is required to produce… conditions which early oil production did not fulfil. Most crucially, however, cartels only work when members cooperate. But since the more successful a cartel is at raising prices, the bigger the payoff for producers who refuse to join it and members who decide to overproduce, all early attempts at cartels collapsed.

Though oil was initially drilled for the kerosene fraction (oil is refined into many different fractions, more), two things happened around the turn of the century: electricity started to dominate illumination in place of whale oil and the invention of the gasoline-powered internal combustion engine put the last nails in the coffin of our society’s addiction to oil. 

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McNally takes a matter-of-fact approach to John D. Rockefeller’s business tactics of the day, and despite strong modern criticism of his practices paints Rockefeller as a (self-interested – it benefited him to have stable raw material prices for his refineries) provider of stable crude oil prices as evidenced by the graph above. This picture is corroborated by the fact the period following the breakup of Standard Oil, oil prices returned to their pre-Rockefeller levels of volatility. McNally correctly attributes this inherent volatility to the inelasticities of demand and supply in the market – i.e. their insensitivity to price changes: it takes time to bring oil to market and once it’s on the market it’s expensive to take it off.

Another period of stability occurred thanks to the successful efforts of Oklahoma and Texas to control domestic production and the relative cooperation between the Seven Sisters, 7 large oil and gas multinationals who in 1949 held 82% of non-US reserves and controlled 57% of global refining capacity. This is also evidenced above. 

Ironically, it is suggested that the formation of OPEC in 1960 was inspired by the activities of the Seven Sisters. Despite representing 80% of the world’s oil exports at the time, OPEC was ineffective at controlling prices in the 60s, but this was to change in the 70s.

This period is portrayed as one of price control shifting from Western MNCs to producer countries, and this would have significant consequences for Western foreign policy, consequences which McNally is able to artfully draw out. During the 1957 Suez Canal crisis, the US was able to avoid calamity despite the 10% global supply disruption because it had spare capacity. But thanks to demand stripping ahead of supply, US spare capacity as a proportion of global demand fell from over 15% to less than 5% from 1960-70, so in 1973 when OPEC raised prices to 6x 1970 levels, the US was forced to fall back to a strict regime of price controls and allocations that would last for up to a decade. The geopolitical center of gravity had shifted, and very few people noticed.

“It is difficult to overstate the depth of the gloom that descended on western officials and business people in the 1970s at the prospect of massive future dependence on Middle Eastern oil imports… Oil prices were at the heart of world commerce, and those who seemed to control oil prices were regarded as the new masters of the global economy.” 

Bush Jr doing sword dance with Saudi officials; Trump 

Despite promising to provide stability (albeit at higher prices), the OPEC period is characterized as a period of increased volatility caused by an inability for OPEC to control its members. Essentially, a seller’s market turned into a buyer’s market as some politically motivated OPEC members such as Venezuela and Nigeria who desperately needed the revenue sold oil on the spot market in defiance of official quotas. Essentially, OPEC members were in a classic prisoners’ dilemma situation and they simply never cooperated for a sustained period of time. For example, in order to gain market share in 1985, Saudi Arabia implemented a pricing policy that would guarantee refiners a fixed margin, which resulted in doubled production (2.2 mb/d in August to 4.5 by December) – other OPEC members immediately followed suit.

 “OPEC as a group almost certainly will not regain control of the market; it would require members to achieve a level of cohesion and discipline it has never shown. OPEC’s role as a cartel, as this book and other research has shown is vastly overstated. There is little evidence OPEC quotas affected members’ production; one researcher found OPEC produced in excess of official quotas 96 percent of the time between 1982 and 2009.”

Next:

  • While global oil production has almost definitely peaked, US crude production is having a renaissance (contravening famous predictions that it would approach exhaustion by 2018) – profound consequences for future foreign policy
  • US has flirted with the idea of using strategic reserves (total capacity = ~35 days of consumption) to stabilize prices, but thankfully realized how prone to politicization this might become
  • Oil prices hit >$100 in 2008 due to fundamental supply/demand mismatches with Russia/Iraq/Nigeria producing less oil and China consuming more 

Shale oil

The shale oil phenomenon is captured in the above two figures. It’s resulted in a substantial recount of US proven reserves, and due to its production curves and the number of producers (independent wildcatters), it makes price stability a distant possibility.

In response, Saudi Arabia gave up their role as the swing producer – one to cut output in order to maintain prices – in the belief that shale breakeven levels were ~$60. Continuous technological innovation and sunk costs lead to shale oil producers to continue to produce, however, and prices went sub-$30 in early 2016, but Saudi Arabia wouldn’t budge on cutting production. Back to boom and bust it is.

For context global oil production is ~100mb/d and top 10 countries: