A TENTATIVE ANALYSIS OF CRUDE OIL PRICE VARIATIONS OVER A 175 YEARS PERIOD

December 2014

 

A.    After refining, crude oil is used mostly in four forms

1.    Fuel for road, rail, marine, and air transportation

2.    Fuel for residential and industrial heating

3.    Raw material and fuel for the petrochemical industry

4.    Electricity generation (used extensively for electricity generation in some regions; about 6% of global oil production is used for that purpose overall)

 

B.   Trade

Producers sell crude oil physically to refiners, with which they are sometimes integrated, directly or through traders, either for cash or through futures contracts or options. Part of the production is stored for later release, either by producers or buyers, or by governments, depending on market status. Production is currently about 90 million barrels per day (mmbbld) and, as an average, producers transfer to refiners a daily quantity equal to one day of production.

 

C.   Financial markets

In parallel with the physical spot market where crude is sold for cash, there are important financial markets, in the U.S., in London, in the Middle East and in Asia, where financial instruments derived from physically traded crude oil are exchanged, mostly as options or futures. The total volume traded daily is between 20 and 40 days of production. There are two categories of traders in these markets : those who produce and use crude oil, and those who trade the derivatives with a financial purpose only. The number of contracts traded in each category is more or less equivalent.

Some observers contend that the trading of 20 to 40 days of production would lead to out-of-hand speculation and market manipulation, but it seems that apart from some short-term fluctuations, such is not the case, which numerous academic studies seem to confirm by observation of significant price variations. In fact, all that is produced once storage is full must be sold immediately to refiners for eventual public consumption, at whatever price the market will bear, and the total available intermediate storage capacity represents only a few days of production. The only way to drive the price of the commodity up voluntarily is to create a relative shortage by either reducing production and therefore leaving the commodity in its production basin, or storing it somewhere between production well and  consumer. The only party able to store all or part of crude oil production in the long run is crude oil producers, in the production reservoirs.

 

D.   Physical storage

Crude oil can be stored in various ways :

1.    On land: in storage facilities, above- or underground. World storage capacity is 45 days of production, 15 days belonging to governments and 30 to private owners. In the U.S., where 2/3 of the capacity belongs to the government, total capacity is 11 days of world production. Other than governments, these facilities are controlled mostly by producers and refiners. During the last 30 years, capacities have fluctuated by only about 20%, which means that their flexibility is only about 10 days of production.

2.    At sea : global capacity of marine crude oil carriers is about 20 days of production, continuously on the move for the main part, but between 0 and 20% of that capacity, according to market conditions, is on stand-by and can be used as floating storage if needed, for up to 4 days of world production. This kind of storage can be controlled by anyone with the wherewithal to do so.

3.    In the underground reservoirs whence crude oil is produced, each time production either slows down or even stops, according to demand, as is often the case in the U.S. when prices are low, sometime below production cost. Their known capacity is 19,100 days of production (52 years). Producers are the only party able to control these reservoirs. They use them for storage, in an equivalent fashion, when they sell future contracts or options, or when they try to create artificially a general shortage in concert with other producers, a practice that has been illegal in all democracies since the very early 20th century but is tolerated of OPEC members.  

 

E.    Crude oil consumption since 1965

In the U.S., in Europe, and in Japan (UEJ), consumption has been declining for several years. In China, India, and in the Middle East (CIM), consumption still increases, although economic indicators for China and India hint that these countries’ growth is plateauing.

 

cid:image007.png@01D0DF59.26685700

 

cid:image008.png@01D0DF59.26685700

 

F.    Comparing crude oil prices since 1965 with changes in world consumption, changes in UEJ and CIM consumptions, and U.S. stocks, as well as changes in U.S. stocks

Prices are year averages, filtering out or dampening all short term variations. All prices are in constant 2014 dollar. The only correlation, and not systematic at that, is that UEJ consumption decreases when prices increase steeply. CIM consumption is less affected. Changes in U.S. stocks are either in correlation or in opposition with prices.

 

cid:image003.png@01D0DEA3.66D05830

 

G.   History of prices, 1860 to 2015, and probable future

Prices are year averages, filtering out or dampening all short term variations.

cid:image004.png@01D0D78D.4B0CE040

 

H.   Probable causes

Prices are year averages, filtering out or dampening all short term variations. In particular, major unforeseen meteorological events, such as hurricanes on the Eastern seaboard of the U.S. and in the Gulf of Mexico, commonly result in a short term supply disruption that temporarily affects spot prices, sometime greatly, but worldwide annual average prices only marginally.

Since the late 19th century, there have been only two major periods of high prices: 1973 to 1986 and 2004 to 2014.

1.    UP, 1973 to 1980: an embargo is imposed by Arab producers following the Yom Kippur War. Prices increase from $17 to $55 in 1974, down to $50 in 1978 and up to $105 in 1980

2.    DOWN, 1980 to 2004: in 1986 price is down to $31 and continues falling to $18 in 1998. It won’t be until 2004 that prices rise again above $50.

3.    UP, 2004 to 2008: prices rise from $50 to $105

4.    DOWN, 2008 to 2009: prices decrease to $67

5.    UP, 2009 to 2014: prices increase up to $115

6.    DOWN, 2014 to 2015: prices decrease to below $40 in August 2015

 

Historically, if the period from 1860 to 1880 is excluded as being pre-self propulsion age, prices between 1880 and 2015 (135 years) were above $40 in constant 2014 dollars only for 23 years (17% of the time), in two periods of 13 and 10 years.

It seems that warfare and political events are not necessarily synchronous with price variations, and neither is U.S. storage capacity.

All three price increases were triggered by deliberate efforts by Arab producers to manipulate markets through production cuts.

After each of the first two occurrences, market reacted by a drop of consumption. The first drop, from 1979 to 1983, was of 6 million barrels per day. A drop of 7.3 million barrels per day occurred in the U.S., Europe, Japan region (UEJ) but was dampened by the rise of Chinese, Indian, and Middle Eastern (CIM) consumption. From 2005 to 2015, the drop of UEJ consumption was 5.4 million barrels per day, again dampened, and soon compensated, by an increase of CIM consumption.

Additionally, the major event during the second high price period was the development of U.S. unconventional production and the synchronous decrease of U.S. imports. Between 2006 and 2015 U.S. production increased by 3.7 million barrels per day and imports decreased by 4.6.

All price decreases were triggered by a decrease of either global or UEJ consumption. The 2009 price increase saw the conjunction of the threat of a large production cut and a temporary pause in the UEJ consumption decrease.

Although price variations appear to be sometime irrational in their amplitude, occasionally responding hyperbolically to perhaps unreasonable fears, it seems that price variations respond exclusively to supply and demand forces, influenced by political events only as far as these induce OPEC producers to cut production drastically from time to time. Each major price increase followed deliberate production cuts calculated explicitly to manipulate the market. Each major price decrease followed significant decreases in UEJ consumption, which exceeded production cuts and were made possible mostly by efficiency improvements. Furthermore, increasing U.S. production resulted in decreasing imports. Some of the dips in consumption were no doubt due to production cuts, but the 2009 threat of a 4.2 million barrels per day production cut was followed by an actual worldwide 7 million barrels per day increase in consumption, showing that either the threat had not been carried out, or production cuts had found a substitute outside of OPEC.

This last circumstance was not lost on Saudi Aramco when it decided not to proceed with production cuts as prices started to tumble in July 2014.

Since the two steep price increases of 1973 and 2004 many things have changed in the oil market, which will no doubt reflect on how prices vary in the future:

1.    OPEC, and particularly Arab producers, do not control anymore a share of production large enough to give them unilateral control of the supply side of market

2.    The U.S. is again the largest producer of crude oil, thanks partly to the development of unconventional fields. The U.S. is also the largest producer of natural gas and the second largest coal producer (behind China). Restrictions on oil and gas exports have been eased by Congress.

3.    The world’s largest reserve has shifted from Saudi Arabia to South America

4.    Consumption in the rich economies, particularly in the UEJ region, has not increased since 1973, mostly as a consequence of technical innovation, and currently continues to decrease

5.    Chinese and Indian consumption give signs of levelling out, a double digit economic growth having become unsustainable in both countries

6.    The “peak oil” scare seems to have been somewhat subdued after it was recognized that despite increased global production, known reserves have continuously increased in the last 35 years: in retrospect, and based on current knowledge, it can be calculated that 1980 oil reserves were greatly underestimated, at ¼ of what their assessment would be today.

 

cid:image003.png@01D0DE5A.DC1C00B0

I.      Coal and natural gas

Coal and natural gas are the major energy sources for electricity generation but compete with petroleum products as raw material for the chemical industry and as fuel for heating purposes, either directly for natural gas or through co-generation for coal in the developed world and directly elsewhere. Since 1981 global energy consumption has increased by nearly 100% but the share of oil decreased from 44% to 33% while coal’s share increased from 28% to 30% and natural gas from 19% to 23%. Renewables increased from 0.1% to 2.5%. Since around 2000 oil lost a 7% share while coal gained 6% and gas was flat at 23%.

Coal is little used for automotive propulsion, the production of synthetic gasoline being less than a quarter million barrels per day, and as regards natural gas only between a half and a million barrel-equivalents per day is produced for compressed natural gas vehicles, but all areas where oil competes with coal and natural gas have a direct effect on global oil demand, and therefore price. It so happens that since 2000 the relative productions of coal and oil have varied in almost exactly opposite fashion, which can explain in part the unexpected assistance volunteered by the oil and gas industry in support of the carbon dioxide greenhouse effect theory, a theory that puts much more blame and odium on coal than on oil and gas.

 

cid:image009.png@01D0DF1C.B626AA50

cid:image010.png@01D0DF1C.B626AA50

 

J.    The probable future

Based on historical data and patterns, as well as relatively recent fundamental changes in the crude oil market structure, it seems average annual oil prices in the next few decades are likely to remain at the $40 average level, oscillating between $30 and $50 a barrel, a level that is higher than during the past periods of low prices because of higher production costs for unconventional petroleum than for conventional. Any technological improvement leading to a cost decrease of unconventional production will put downward pressure on global oil prices.

It could be that the only way to push oil (and natural gas) prices up in the long term would be for concerted government action to put severe restrictions internationally on global coal consumption. Although western governments endeavor to put such restrictions into effect, it seems unlikely that Asian governments, Korea and Japan apart, will follow suit just to please oil interests to the detriment of the consumer and the economy, except of course if intense environmental lobbying gained traction on these governments, an unlikely scenario for the time being in those relatively poor countries (on a per capita basis), where environmental worries, real or imaginary, will remain a luxury until everyone's basic needs are satiated.

 

MMM

December 2014 – August 2015