Is Oil a Bubble?

With Brent bumping up against the $125 mark and petrol/gasoline prices at record highs, many commentators are once again assuming that high prices are the new normal. Maybe. But perhaps not. Here are seven reasons why oil could see a sharp fall.

  1. High prices are being driven by fears of war with Iran. But we’ve been there before. Back in 2009, many were hyping a military strike and nothing happened. If markets get bored of waiting and begin to discount fears of an imminent attack, oil’s risk premium could shrink fast.
  2. Higher prices are bringing more oil onto the market. Iraq is now producing more than at any time since 1979 and hopes to quadruple production by 2017. Saudi Arabia has doubled the number of rigs it has deployed.  Offshore exploration is picking up as memories of the Deepwater disaster fade. Remember too that we’re yet to see the full supply response to the 2008 spike.
  3. At the same time, demand is being choked off by high energy prices. Oil helps explain why the US recovery is so anaemic. Meanwhile, both China and India have revised their growth projections downwards. HSBC has dubbed oil ‘the new Greece’ – catchy, an exaggeration, but at least somewhat true.
  4. Oil prices are putting import-dependent emerging and developing economies under growing fiscal pressure. In India last week, I was taken aback at how vulnerable high energy prices have made the country’s government. Energy and food subsidies have driven the deficit to an expected 5.6% of GDP this year. Many countries will have to cut expenditure or subsidies, or raise taxation somewhere along the line (and face the political consequences of these actions).
  5. The United States is importing less oil than at any time since 1999 – in part due to lower demand (changes in consumer behaviour due to the 2008 price spike are still filtering through the system) and in part due to resurgent domestic supply (tight oil etc.). Together with its growing shale production, this represents a significant shift in the pattern of demand.
  6. Speculative pressures appear to be pro-cyclical and could unwind rapidly. Oil consumers  are hedging (or trying to) against an Iranian supply shock, while pension and index funds are betting that oil will go higher. A change in sentiment could lead to a sudden bout fall in the price, as trade in paper-based oil exacerbates, rather than controls, market risk.
  7. It’s happened before. Brent was above $145 in July 2008. It then fell to $54 in just six months. Admittedly, the bottom had fallen out of the world economy and we seem to have stepped away from imminent catastrophe in the Eurozone, but the historical precedent should still dent the confidence of those who assume that, for oil, the only way is up.

So will oil fall? Much depends on what happens with Iran, of course. Other supply shocks could play a role, which is why reports of an attack on a Saudi pipeline  caused palpitations last week, and why MEND’s seeming resurgence in Nigeria is causing concern.

Oil exporters, meanwhile, are desperate to keep prices high(ish). Their fiscal breakeven points are now worryingly high, as governments use oil revenues to buy off restive populations. Saudi Arabia needs oil above $80 and Iraq above $100 before they start eating into surpluses or running up debt. In Russia, Putin’s tears of triumph may flow for less happy reasons: the Finance Ministry says it now needs S117 oil. Don’t expect to see them rushing to flood the market with supply.

And oil is clearly riskier and more expensive to produce than it was in the long, long bear market that followed the East Asian financial crisis. In the medium term, a new floor is probably being set for the oil price, determined by the cost of production for tight and deep sea oil, and for tar sands, and for opening up resources in some of the world’s least stable states. That floor, though, could be somewhat, or even considerably lower, than the current price.

My sense is that we can expect to see an extension of the current period of volatility. The scenario where prices jump again is realistic, but so is one where we see a lurch downwards. The market seems pretty frothy to me, and too many analysts have jumped uncritically on the high price bandwagon.

Policymakers need to continue to plan for unusually high levels of uncertainty. And they should be sure to ignore the false prophecies of those who claim to know what the oil price is going to do.

A price band for oil? Why not just do a global deal on climate?

As oil continues its crazy gyrations (yesterday’s price – $48), news is proliferating that investment in new exploration and production is falling off a cliff.  Monday’s NYT, for example, had this:

From the plains of North Dakota to the deep waters of Brazil, dozens of major oil and gas projects have been suspended or canceled in recent weeks as companies scramble to adjust to the collapse in energy markets.

Oil markets have had their sharpest-ever spikes and their steepest drops this year, all within a few months. Now, with a global recession at hand and oil consumption falling, the market’s extreme volatility is making it harder for energy executives to plan ahead. As a result, exploration spending, which had risen to a record this year, is being slashed.

The precipitous drop in oil prices since the summer, coming on the heels of a dizzying seven-year rise, was a reminder that the oil business, like those of most commodities, is cyclical. When demand drops and prices fall, companies curb their investments, leading to lower supplies. When demand recovers, prices rise again and companies start to invest in new production, starting another cycle.

Now for Dan Drezner, all this poses a question:

So, let me see if I have this right:

If oil prices are sky-high, the energy sector explains that it will be slow to develop new fields, because exploration requires massive fixed investments and no one knows what the price of energy will be 5-10 years from now;

If oil prices are low, the energy sector explains that it is unprofitable to develop new fields because… energy prices are low.

Well, actually that is more or less the long and the short of it; as I argued back in July, the oil price is set to continue its recent yo-yoing for as long as we continue without a clear ‘signal from the future’ about the long term demand outlook for oil. After all, if you were an investor considering ploughing money into oil fields that were only profitable above $60 or $70 a barrel, and which would take many years to recoup the capital cost, wouldn’t you apply a pretty big risk premium if you saw prices collapsing to below $50 from a high of $147 less than six months earlier, with the potential in the background for future climate policy to cause demand to plummet?

Problem is, though, that without that new investment, we’re on track for a serious price crunch at some stage, as both the IEA and Chatham House have argued.  So how to square the circle?  Well, Nick Butler – who was John Browne’s chief of staff at BP and now heads the chairman of the Centre for Energy Studies at Cambridge’s Judge Business School -has a proposal in the FT yesterday. He writes:

If the energy ministers want to stabilise the market they should begin by commissioning a detailed, independent analysis of what went wrong. They should then develop the stabilising mechanisms that would limit the possibility of any repetition of 2008.

The most effective mechanism would be agreement on a broad target range for prices – say, between $50 and $75 a barrel – backed by a strategic stock holding to be augmented or deployed when prices diverged from the range. To support such an agreement trading would be limited to those with a direct physical interest in the market.

From a new base of relative stability ministers could consider the longer-term issues that will shape the energy market: the huge need for infrastructure investment ($350bn a year according to the International Energy Agency) and climate change.

This idea of a price band is clearly starting to gain ground in the energy think tank world – I heard a very similar idea mooted by an attendee at a Shell / Economist energy breakfast in London last month. But I’m not so sure.  While Nick Butler’s clearly right to refer to the need to integrate energy security with climate change, why not go one step further – and use a comprehensive climate framework to provide the long term oil price stability that’s needed to bring the right amount of new investment on stream?

Think about it.  Imagine a climate regime in which the emission targets are sufficiently long term (i.e. multi-decade rather than in 5-yearly increments as under Kyoto), and which is based on a quantified stabilisation target, which therefore means that all major emitters have binding caps. (You can argue about political feasibility in the current political climate, but the fact remains that a global deal on climate that actually solves the problem will have to satisfy these conditions anyway – and sooner rather than later if we’re to limit warming to two degrees C.)

What such a regime would also achieve, with no extra work needed, is to provide long term predictability on how much fossil fuel will be being consumed – for decades ahead.  True, it wouldn’t tell you exactly which fossil fuels – coal versus oil, for instance – but since they’re used in different markets (oil mainly for transport, coal and gas mainly for power generation and heat), you could make a pretty good guess.

And now imagine again that you’re the potential energy investor we met earlier.  All of a sudden, you can invest with much more confidence – and what’s more, knowing the level of demand will enable you to watch what other investors are doing too, so that more or less the right amount of new oil is brought on stream to meet projected demand, within the context of a global deal for climate.

Oh, and there’s one other advantage: given that a global deal on emissions is primarily an agreement between energy consumers, you can worry just a little bit less about OPEC’s congenital inability to stop itself from cheating

Update: meanwhile, “OPEC oil ministers meet on Wednesday to remove a record 2 million barrels per day from oil markets as they race to balance supply with the world’s collapsing demand for fuel … Saudi Arabia, the world’s biggest oil exporter, has led by example — reducing supplies to customers even before a cut has been agreed to help push prices back toward the $75 level Saudi King Abdullah has identified as “fair.””