The last time the price of oil nose-dived was in 2015/2016, when it plummeted to 28 dollars a barrel after years of relative stability at over 100. OPEC was seen to be powerless, but soon the Russians and Saudis decided that a little conflict of interest over Iran and Syria should not preclude brotherly collaboration between two great oil-producing nations. Money first. After some discussion, they reached an agreement and the price rose again, initially to over 80 dollars a barrel before finally zig-zagging between 50 and 60, a fair figure that suited all involved.
Today, the price of oil is crashing again, but instead of coming to an agreement, the two nations are at each other’s throats. The show is hardly going to be repeated, despite the new OPEC+ meeting scheduled on April 6th. In fact, it would be impossible to do so, because the theatre itself is different. In 2017, the question was merely one of adjusting over-production to suit the level of demand, at a time when trends were relatively foreseeable or modellable, based on economic growth and developments in energy efficiency. While impossible to determine an exact figure, it was nevertheless reasonably worthwhile to try to estimate the cut in output needed to rebalance the market before distributing production equitably among the various players.
But the problem then was over-production. Today it is the novel coronavirus. It is not a matter of economic cycles but of epidemiology. The longer the disease remains unchecked and the further it spreads, the bigger the hit the global economy will take. Where it will all end, nobody knows. Forecasts can only be likened to shots in the dark. So what is the point of agreeing on cuts and quotas in oil production if you have no way of knowing whether they will defend the price of oil?
In these new circumstances, indeed, an effective agreement to push the price up can hardly been reached. It’s every man for himself. If you cannot keep the price up, at least you can try to stabilise production, or rather to maintain your slice of a market in which demand is collapsing. The Saudis, who benefit from the lowest production costs, are pumping more oil and selling it at a discounted price to acquire as large a share of the market as possible. The Russians are holding out. The Americans are in difficulty, beset by high production costs. Producers with low production costs are pumping like never before to capture the market from those with higher costs. This sounds more like normal competition than a malicious plot. Take three doll manufacturers, and make their market collapse. The one with the lowest production cost will survive; the one with the highest production cost will be the first to succumb (assuming, of course, that they all three serve the mass market; sales of Prada dolls are governed by a different logic). When demand collapses, it is the market that decides prices and the very survival of each player. This applies to oil in the same way it applies to dolls. The sole difference is that, in the case of oil, the talk is of “war” rather than “competition”, simply because oil is infinitely sexier than dolls.
So much for pricing during the coronavirus crisis, although crises cannot last forever. These are not normal times and price shifts are not likely to be entertaining, unless, of course, the state turns up to save the bacon when the heat rises. US President Donald Trump has announced that he will purchase American-produced crude until the Strategic Reserve is at full capacity. It sounds as if he is going to save the nation’s oil industry. Unfortunately, the Reserve’s estimated residual capacity is only 77 million barrels, less than one day’s global output (net of American oil) and only equivalent to about a dozen days of US shale oil production. The president will have to do a whole lot more to revive the good old days of American protectionism for oil, I’m afraid. For now, the Americans can only hope the present crisis will pass quickly and pressure their allies to find a new agreement on production cuts, as Trump just did.
What is most anomalous about the current situation is that oil producers do not normally behave according to the doll manufacturing model. Typically (excluding, therefore, the present crisis), competition between them is weak or non-existent. There is even a tendency to form cartels. However, while cartels are highly effective when the pickings are rich (robust demand, high prices), they do not work well in a buyer’s market. The cartel system is great, but if the going gets tough you must be ready to compete, or even fight. In his Essentials of Petroleum, Fraenkel (one of the great oil economists of the last century), described a “control–cum–competition” model. What he wrote back in 1946 concerning the behaviour of the major private oil companies applies perfectly to today’s oil-producing nations.
In an industry virtually free from antitrust regulations, the rules of market competition (our doll model) really apply only in times of crisis. At the end of the present emergency it should therefore be possible to return to normality. Perhaps as early as the second half of this year, we may see equilibrium restored, oil prices returning to their previous level (50 – 60 dollars a barrel), and even America’s independent oil companies breathing freely once more.
This time it may still work. But may be the model is not replicable forever. An idea is (slowly?) gaining ground. And the (new?) idea is that we have already discovered and rendered exploitable more oil than we shall actually need in the foreseeable future. If decarbonisation policies prove successful, the value of certain reserves, still in the ground, may fall to zero. Technically speaking, they would become “stranded assets”.
We have no forecasting model capable of telling us if, when or to what extent a stranded asset scenario will occur (or rather, our estimates cover the entire swing of the pendulum from “it’s already happened” to “it may never happen”). Oil-producing nations cannot however wait for such a model to become available. Their sales strategies must consider the risk that they are sitting on massive assets that will only be of use in the short term. No nation can afford to be guided by hope or rosy visions of the future.
In 1931, Harold Hotelling wrote an essay that is still highly influential in the economic analysis of non-renewable resources and that, irrespective of intentions, can provide a useful reference for the strategies of oil-producing nations today. In short, you must decide whether to pump your oil or leave it in the ground. Hotelling’s (simplified) rule is that if the value of your reserves grows faster than the market interest rate, you would do well to leave them in the ground. Vice-versa, if the value of your reserves grows at less than the market interest rate, you would do better to sell and re-invest in a different activity with returns equal to or higher than the said interest rate.
Now imagine that the Saudis have studied Hotelling (and we can bet they have), that their production costs are the lowest in the world (we can be sure of this, too) and that they foresee that some of their known reserves may become stranded assets and will have to be deleted from their accounts in 5 or even 10 years. What would you do in their place?
One possible scenario is that the Saudis will decide to pump all their pumpable oil as fast as they can, down to the last dregs. “With our low production costs, we can destroy the competition and keep others out of the market until we have finished our reserves. We’ll sell all the oil we’ve got and then we’ll see who is left stranded!”
This may seem a bit extreme, like something taken from game theory but if, for example, the Saudis were to start to replace spot contracts with long-term ones, to introduce guaranteed minimum volumes (“take or pay” or similar clauses) and perhaps even to offer further price discounts, it would signal that they have indeed studied Hotelling very closely and that with simplicity, convenience and caution in mind, they are putting his ideas into practice. If so, the doll model might outlive the coronavirus emergency or just reappear thereafter to become the oil industry’s new normal.
