As the global oil market — not to mention the broader economy — is learning, the real game changer is not the North American shale oil boom. It’s that there is no longer a supplier group willing or able to stabilize prices. The result has been wildly gyrating oil prices when OPEC producers are called upon to balance supply and demand. Though counterintuitive, from a price stability perspective, the only thing worse than OPEC managing the market is OPEC not managing it.
It is often forgotten that since the inception of the modern oil market in the 1850s, oil’s extremely low short-run price elasticity of supply and demand has subjected prices to large swings when fundamentals are unbalanced. For both producers and consumers of oil, this boom-bust tendency is unacceptable. For most of the oil market’s history, a dominant swing supplier or group of suppliers has emerged to attempt to suppress this intrinsic volatility by modulating supply. John D. Rockefeller Sr.’s Standard Oil Co. was the first such main oil producer in the late 1800s. The period before and after his era of control saw wild price volatility. Starting in the 1930s the Texas Railroad Commission and Seven Sisters oil companies managed the market for 40 years until the U.S. ran out of spare capacity in 1972, at which point OPEC, and specifically Saudi Arabia, took the reins. Riyadh’s turn to run out of spare capacity came in 2008, when it was unable to prevent prices from soaring to $145 a barrel, contributing to a spectacular demand and price collapse to $34 shortly thereafter. OPEC and Saudi Arabia, in which it is a dominant player, have since been unable without help from soaring U.S. production to impose a ceiling on prices, which hit $115 a barrel in June 2014. And as demonstrated in November, OPEC is unwilling to impose a floor under prices.
With no supply manager in charge for the first time since the 1920s, the market has entered an era of heightened proneness to large swings — a dynamic similar to riding Space Mountain, the thrilling for some and terrifying for many roller coaster ride familiar to generations of Disney theme park visitors. Until this past summer, the Space Mountain view about oil prices appeared misplaced. From 2011 until then, volatility had fallen to lows not seen since the early 1980s owing to a fluke combination of tepid global growth in gross domestic product, surging U.S. production, destocking and massive central bank easing.
If prices resembled any Disney ride from 2011 through mid-2014, it was It’s a Small World. But a weakening macro outlook and returning Libyan crude production tipped the balance into oversupply this summer. And once OPEC producers in the Cooperation Council for the Arab States of the Gulf (known colloquially as the Gulf Cooperation Council, or GCC) dashed widespread expectations of cuts this fall, price behavior has reverted to the volatility typical of an unmanaged market.
Oil prices are now in implosion mode, shocking seasoned experts and outside observers alike. Gulf producers, chiefly Saudi Arabia, have doubled down on pledges to maintain present levels of output, insisting their competitors (many of whom happen to be their geopolitical rivals) cut first. Although often depicted as a contest between U.S. shale oil and OPEC, it is really more an intra-OPEC conflict, with Gulf Sunni producers Saudi Arabia, Kuwait and the United Arab Emirates pitted against Shia Iraq and Iran for market share in Asia. With no sign of de-escalation, and barring a major geopolitical disruption, commercial inventories and floating storage are headed toward large, counterseasonal builds, with record high supply possible by the end of the second quarter of 2015, forcing spot prices well south of $50 and into $30 territory.
We expect that oil prices will likely stabilize only in the $30 to $50 range, which will impair new investment in shale oil and other high-cost supply projects while delivering a strong message to oil-revenue-dependent producers like Iraq, Iran and Russia that they had better trim supply if they want Gulf producers like Saudi Arabia to cooperate in getting crude prices closer to $100 a barrel.
But looking down the road, when GDP growth picks up, get ready for the mother of all price rebounds. The duration and amplitude of its bottoming out will depend in part on the timing and amount of cuts extracted from non-GCC producers but primarily on the return of healthy GDP growth. The pace of efficiency gains has been slower than widely believed, and therefore demand growth will be larger than consensus expects. Given oil demand’s high sensitivity to income growth, when GDP picks up toward trend levels, oil demand will rise sharply.
If, as most observers expect, net supply growth reaches 1 million to 1.5 million barrels per day, then once-accumulated inventories would be worked off, the small remaining OPEC spare production capacity would be exhausted, and oil prices would have to rise substantially to balance the market. Now that the oil price war of 2014 is about to lay waste to capital expenditure, this implies even higher oil prices when economic growth recovers.
The key uncertainty is the timing of global economic recovery. Whereas growth is thirstier than commonly believed, International Monetary Fund forecasts may be too rosy. Its current 3.8 percent global GDP growth rate projection for 2015 will likely be revised lower. Official forecasts for 2015 oil demand have already been slashed, and we haven’t had a growth scare yet. But whenever the world finally grows closer to 4 percent than to 3 percent, oil prices are likely to head back toward $90 a barrel and, with future disruptions, well above $100.
On Space Mountain, the ascents are as hair-raising as the drops.
Robert McNally is president and founder of the Rapidan Group , an energy consulting firm, in Bethesda, Maryland.
Get more on macro .
