Streetwise Professor

December 31, 2014

The Oil Price Decline: No Conspiracy Theories Need Apply

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 11:50 pm

2014 is in the books, and fittingly the last day of the year  saw a fall in the price of oil. The nearly 50 percent decline in oil prices from the end of June to today was the biggest commodities story of the year. This decline has spawned numerous conspiracy theories, which like most conspiracy theories, are pure bunk.

Most of the stories focus on Saudi Arabia and shale oil. In some versions, the Saudis decided to crash the price of oil to drive out competition from US shale production. I analyzed, and dismissed, this story some weeks back. In other versions, the Saudis decided to crash the price of oil in order to strike a blow at its arch enemy Iran, or in some variants, at Iran and Russia (either in cahoots with the US, or to punish Russia for its support of Assad).

Well, to crash prices it is necessary to increase output. The Saudis, however, did not increase output over the past 6 months: it has remained relatively static. This couldn’t be more different from what happened during the 1985-1986 price collapse, to which the most recent decline is often compared. In the early-80s, the Saudis cut output from about 10 million barrels per day (mmbpd) to as low as 3.5 mmbpd in order to maintain prices in the face of rampant cheating on output quotas by other OPEC members. Realizing that it was being the chump, the Saudis increased output about 44 percent. Nothing like that has happened in the past six months.

The other purported cause of the price decline is the increase in US output. This increase is indeed remarkable, but its timing and magnitude doesn’t explain the price decline. US output has been rising inexorably for a couple of years, and the rate of increase has exceeded forecasts, but not by nearly enough to explain the post-June price decline. Since June, US output has risen by about 100kbpd per month. Cumulatively, that’s about 600kbpd, or a less than .7 of world output. Even using an elasticity on the high side of 10*, this could account for about a 7 percent decline in the price. What’s more, some of the US increase has been needed to offset the on again, off again production in Libya and declines in production in Mexico.

Meaning that the focus on the supply side has been totally misplaced. This in turn implies that all of the hyperventilating about S&S-Shale and the Saudis-is wrongheaded.

Instead, the most likely explanation for the price decline is a decline in demand. The fall in price parallels quite closely declines in world GDP forecasts. Chinese manufacturing in particular has slowed. This has been reflected in other commodity prices which are driven by Chinese industrial demand, most notably iron ore, which has fallen almost 50 percent over the last year, and copper, which has fallen by about 15 percent since June. And somehow I don’t think the Australians or Chileans are attempting to punish their economic rivals or geopolitical enemies. They are just along for the ride on the demand train.

The biggest price daily oil price decline occurred the day after Thanksgiving, when OPEC announced it would not cut output. Prices have also declined on days when the Saudis or other Gulf states reiterated their intention to maintain output. But maintaining and increasing output are two different things. The Saudis didn’t announce that they were opening the taps, like they did in 1986. They are just saying they won’t shut them. And as I argued in an earlier post, given their market share and the elasticity of demand for oil, that’s a rational thing to do without having to resort to predatory explanations.

Again, although most analysis focused on supply, the post-Thanksgiving price decline was really attributable to demand too. Market participants were predicting that OPEC would cut output to support prices in the face of falling demand, and this expectation helped to prop up prices. When the expectation was contradicted, prices fell.

I was only surprised that people were surprised that OPEC didn’t cut output. I didn’t see that happening, and I was right: The Saudis only cut output very modestly (by about 3 percent) during the price collapse in the aftermath of Lehman. Where I was wrong was not understanding that it appears that it was almost universally believed that OPEC was almost certain to make a large cut: I was right about the Saudis, but wrong about what everybody thought about the Saudis. This is why I am blogging, rather than sipping Mai Tais on a yacht that would make Abramovich green with envy.

So, it’s not exactly a case of move along, there’s nothing to see here: the price decline is certainly worth watching. It’s just that what you are seeing is not the result of some grand scheme engineered by the Saudis or anybody else. If there is any scheming going on, it is China’s attempt to move to a more sustainable growth model that is less dependent on stimulus-driven investment in industry and infrastructure.

It is certainly the case that the decline in commodity prices generally, and the oil price in particular, could have -and is indeed already having-seismic economic and geopolitical consequences. It is definitely the case that Russia and Iran are going to suffer mightily as a result of the price decline. This may in turn force them to dial back their geopolitical ambitions, although particularly in the case of Russia it could lead to the opposite response by a desperate leadership. But just because these outcomes might be desirable to the US or the Saudis doesn’t mean that the price decline was deliberately engineered to produce them. They are just consequences of broad economic developments that were intended by no one. For the Saudis, the unintended geopolitical consequences at best palliate some serious economic pain.

Given that (unlike in 2008-2009) the demand decline isn’t due to weakness in the US economy, on the whole the US will benefit from the lower oil price, though some regions (like here in Texas and in North Dakota) will obviously suffer. Drilling activity in the US will decline, but this shouldn’t warm Saudi hearts, because if demand rebounds and drives up prices, drilling will rebound too. The oil and the technology aren’t going anywhere: they are on tap for when the price is right.

Recent academic research shows that most of the price variations in oil over the past decades have been demand driven, rather than supply driven. This most recent decline is just another example of that.

Conniving oil ticks and outlandish Texas oilmen make colorful copy , but usually the world is much more prosaic. Oil supply is very inelastic in the short run, so when demand declines even modestly, prices can plunge. This is counterintuitive to most: how can small changes in demand have such huge effects on prices? This leads to speculations about conspiracy, especially when the price changes can shake nations like Russia to their cores. But such speculations are idle. The normal operations of commodity markets routinely produce such price movements. Which is precisely why subjecting grandiose ambitions for geopolitical power to the vicissitudes of commodity prices is the strategy of fools.

And yeah. I’m looking at you, VVP.

Putin may not be having a happy New Year, but I close this post by wishing all my readers all the best for 2015. Enjoy the schadenfreud!

*This elasticity of 10 is related to the sensitivity of oil consumption to prices. Speculative storage makes oil demand more elastic. Indeed, in response to the price decline, visible speculative storage (primarily at Cushing) has increased, and the market has moved into a contango, which is associated with greater storage.

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15 Comments »

  1. If the road turns and you don’t you end up in a ditch even though you did nothing.
    If the demand decreases and the Saudis do nothing the price crashes, even though the Saudis did nothing.
    As far as all the conspiracy theories go, they might all be true or not. No mutual exclusivity here, just degrees of truth.
    But you can bet the Saudis are happy that shale oil is feeling a pinch even though they did nothing. Same for the Iran and Russia theories.
    Only the Saudis can afford to keep pumping oil all day at $55. <——-
    Maintaining production while the price drops below everyone elses cost of production is NOT doing nothing.

    Comment by Andrea Silver (@andilinks) — January 1, 2015 @ 12:42 am

  2. As the Professor points out lower oil price is just a scheduling issue for shale production. Attractive oil price supports active drilling and unattractive oil price results in reduced drilling. The CAPEX is all associated with drilling and completion with little required for infrastructure. The fixed OPEX is relatively low. Shale production is similar to a manufacturing process in that you can easily adjust output consistent with market conditions. That is an advantage it has over offshore developments that require years of engineering and construction prior to first oil production. With shale oil price is good you drill and if bad you don’t.

    I receive looks of disbelief and confusion when I tell people this is not a Saudi attack on shale but rather demand driven.

    Comment by pahoben — January 2, 2015 @ 12:31 am

  3. I think you’re missing the elephant in the room.

    As you know I have been predicting this collapse since late 2011, but I didn’t think it owuld take this long to come about.

    In my analysis we’ve seen (or rather, not seen) massive opaque financialisation of crude oil over the last 10 years through prepay transactions conducted (by definition) off exchange. This created a Dark Inventory (as Izabella Kaminska termed it) of oil stocks in tank or even reservoirs in which the economic value of the oil is no longer owned by the producer but lent to investors using prepay contracts.

    In my analysis, the Saudis (who were not involved in the first five year macro manipulation, whch was a private sector affair between an IOC and an investment bank) entered into a geopolitical bargain with the US from 2009 onwards to peg the oil price. They lent oil to passive ‘inflation hedger’ funds in exchange for dollar loans from the funds, and it was IMHO the ending of QE in late 2014 which essentially pulled the plug on this financial demand.

    I found this recent chart to be circumstantial evidence.

    http://static.cdn-seekingalpha.com/uploads/2014/12/22/saupload_US-Oil-Price-v-Fed-QE.png

    I also found Al-Naimi’s recent throwaway remarks about bridging deficits by borrowing pretty illuminating.

    (Interviewer) But you have announced that you will have a budgetary deficit?

    (Al-Naimi) A deficit will occur.

    (Interviewer) But what resources do you have in the country?

    (Al-Naimi) We have no debt. We can go to the banks. They are full. We can go and borrow money, and keep our reserves. Or we can use some of our reserves.

    If you view market events in recent years through an assumption that there has been massive unseen financialisation using prepay ‘oil loans’ then several otherwise inexplicable market phenomena are accounted for.

    Comment by Chris Cook — January 2, 2015 @ 8:07 am

  4. This is a bit splitting hairs, here. The demand obviously played a large (decisive) role, but there was also an impact from supply expectations, as very clearly proven by the violent Thanksgiving market reaction. Crude dropped 10% in a day right after. Even for oil market, that’s a large move. SA had played a role of swing producer before and this time it refused to play ball. Whatever their motivation, that was clearly a choice. You can pack lots of stories into it: Russia, Iran, shale.

    As to shale being there no matter what. Yes, the technology stays and so do the plays, but costs go up. The risk premium for either engaging into the business or hedging it off, will go up. That’s what you get when you have 50% price swings. The net effect is that the recovery (and further growth) in production will take longer. On the other hand, down the road, it’s likely to make prices higher.

    Comment by Krzys — January 3, 2015 @ 12:54 pm

  5. @Krzys-The surprise was that KSA chose not to offset the effect of declining demand by reducing output. But the underlying shock that set the stage for the Saudi non-decision was a decline in demand. No demand decline, it wouldn’t have been an issue.

    I think the explanation for the Saudi action is straightforward. Given its market share (around 10 percent), the elasticity of demand for oil (10 on the high side) and the elasticity of supply of shale, the demand curve facing the Saudis is pretty elastic, meaning that their revenues would decline if they cut output. No need to invoke great conspiracies.

    I am skeptical that the long run supply curve of shale production has shifted as the result of these developments. Certainly not by enough to mean that the Saudis could recoup the losses they are suffering today with higher prices and revenues in the future.

    The ProfessorComment by The Professor — January 3, 2015 @ 5:32 pm

  6. […] Pirrong has a great post debunking all the mind-numbingly obtuse oil conspiracies doing the rounds following the price collapse in […]

    Pingback by Oil and dollar conspiracies | Dizzynomics — January 4, 2015 @ 9:20 am

  7. There will be another effect of the US shale, even if it is not producing: the knowledge that it is there and could produce if it is required. The presence of US shale oil has done much to calm oil supply fears, generated by a recent belief that any new production would have to come from areas which are technologically demanding or politically unstable. 600kpd of US production probably has a similar market effect of a larger production from somewhere like Nigeria, for example. Despite Obama’s best efforts, the US is still seen as a politically stable place to do business.

    Comment by Tim Newman — January 5, 2015 @ 9:45 am

  8. @Tim-Absolutely. Shale has made the long run supply of oil much more elastic, and it is much more flexible and scaleable than megaprojects. It therefore has much greater optionality. The Saudis have to understand this, and realize that it’s pretty futile to try to drive it out. I’d wager that current events are suppressing future supply from megaprojects, or projects in politically unstable locations, much more than future supply from shale.

    The ProfessorComment by The Professor — January 5, 2015 @ 10:14 am

  9. great post. really great post. So, what you are saying is Obama is in bed with Putin by vetoing the Keystone Pipeline? (Just kidding, and posting yet another conspiracy theory)
    Happy New Year

    Comment by pointsnfigures — January 8, 2015 @ 6:12 am

  10. @pointsnfigures-Thanks for the kind words. Not in bed with Putin, because I don’t think Keystone has that big an impact on Russia, but I can definitely see Obama sympathizing with the Chavistas, who would be the biggest losers from Keystone XL. Probably not a determinative factor, but something that helps tip the scales.

    The ProfessorComment by The Professor — January 8, 2015 @ 7:21 pm

  11. Along the lines of 7-8, it seems to me that a lot of people were speculating that shale wells would drop off faster than they have, and that common knowledge of the higher long-run production from wells and fields in the U.S. might have hit suddenly–it becomes clear that everyone knows that everyone knows that…–where before it was more widespread private opinion.

    Comment by srp — January 8, 2015 @ 9:24 pm

  12. […] pump priming isn’t manufacturing demand.  The net effect of government spending is a multiplier of 0.  Craig Pirrong of the Streetwise […]

    Pingback by Is a Bubble Popping? Points and Figures — January 14, 2015 @ 6:06 am

  13. >Instead, the most likely explanation for the price decline is a decline in demand. The fall in price parallels quite closely declines in world GDP forecasts.

    Does this imply an impending world-wide recession? How soon? How bad? Who will suffer the most? China?

    Comment by vlad1 — January 20, 2015 @ 3:54 am

  14. […] фактор отошел на второй план. Но, как следует из исследования профессор Бауэрского бизнес-колледжа Крейга […]

    Pingback by Китайская угроза: как замедление экономики КНР повлияет на нефтяные цены - Gaming WordPress theme — January 21, 2015 @ 3:38 pm

  15. Conspiracies theories are theories till they become.. Facts! Per instance, irak and the so called “arms of mass destruction” or in the 80s the will of president reagan to destroy the ussr in collaboration with the saudis. Great success has been achieved

    In the other hand, till now the saudis were the swing producer, now its the us shale. Thats normal. Many shale producers are hedged at higher prices but mostly of thise edges will expire at the end if this year then we will probably see au lot of bankrupt, production will drop and price will go up again next year. From my view the saudis will help a little bit if in the meantime a political solution has been found wih the russians..

    I think that its naive to believe that the markets are controlling everything!

    Comment by philip — January 29, 2015 @ 4:29 am

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