OK so that is a classic LinkedIn banner headline designed as click-bait… :-)  the original was going to be “Why oil will go to $20/bbl and why it won’t stay there..”, but since I started writing this in mid-December 2015 procrastination has now made the old headline a bit mainstream…  

Despite this, the core argument remains – not that oil will go to $20/bbl in the short-term (it may well…) but that the long-term price of oil should be $20 or below.   “Should” is only relevant from supply and demand perspective – the geopolitics of $20/bbl oil mean that it is unlikely to stay there.  Could the “Green revolution” in energy lead to war?

The conventional wisdom on oil as a resources has been that of oil as a finite resource leading to Peak Oil panic – which was widely commented in mainstream media and widely dismissed within the industry.  Probably the best antidote to Peak Oil Panic I heard (and I apologise as I don’t know the source) was “when you can talk about Peak Technology, then we can talk about Peak Oil…”.  With a bit of hindsight this has proven to be very true at the current time.  US oil shale has been a technology driven source of new supplies.

In 1968 Garrett Hardin published the influential paper in Science “The tragedy of the commons” – which was a amongst other things, a call to abandon the cold-war arms race.  Above and beyond the main argument that humans would act in a rational-but-selfish manner to the detriment of shared resources (the “commons”), he also argued that there was a class of problems that had no technological solution.  The arms race being one.

The use of finite resources may also be seen as a member of this set.   Technology in the oil industry has caused a temporary supply side excess, and indeed I think most people in the industry can see that a combination of technology and price could keep us supplied for generations, even if it does not alter the fact that fossil based hydrocarbons are a finite resource.  Technology can’t change the fact that fossil fuels are finite – although it may well render them obsolete.

The finite nature of oil has led to a generally accepted view that oil prices will inevitably rise over time as scarcity sets in and F&D costs increase.  This was very much the driver of the Peak Oil debate mid last decade.  However, it now seems likely that the opposite is becoming a reality – demand will decline before scarcity of resources becomes an issue.  In this brave new world, permanent over-supply and consequent low prices may be the main theme.

As noted in a previous post, I believe we are close to “Peak Demand” – with the rise of Electric Vehicles as the biggest factor in demand destruction.  You don’t need all vehicles to be electric for the impact to be seen.  My back-of-the envelope guess is that circa 15%-20% of OECD cars and trucks running on electricity will take out 8-10% of the world demand for gasoline.  Gasoline accounts for roughly 50% of crude – so 10% of 50% of 96mmbbls/day is roughly 4-5mmbbls/day of demand destruction.  Considering the importance of the over/under supply-volumes in dictating price in a non-monopoloistic market, taking 4mmbbls/day out of the demand would depress prices long-term.

The Stone Age came to an end not for a lack of stones and the oil age will end, but not for a lack of oil. – Ahmed Zaki Yamani, 2000

Obviously the industry would react and would shrink. As we are seeing today, high-cost projects (where ‘cost’ is in $ terms but also in ‘cost of doing business’, so ‘hard’ countries will be exited) will be abandoned.  Today we believe that the current levels of under-investment will lead to a major price correction/spike.  However, projecting forward 10-15 years, with accelerating usage of EVs, there will be a continuous erosion of demand that will lead to a significantly shrunken industry.  Those left standing will be the low cost producers in the Middle East.

Based on the above view we could foresee very low prices being the norm, but low prices come with a cost.

The problem with this is that low prices don’t suit the main producing counties.  We have all seen figures of what oil price producing counties need to balance their budgets, ranging fom $70/bbl to $120/bbl and above.   Saudi Arabia used some $12bn per month last year subsidising itself.  At that rate its cash reserves would last 5-7 years.   The pattern is repeated across the main producing counties, where bloated states have become painfully reliant on oil revenues.   This is not to say that there are multiple levers that can be used to delay the inevitable, but nonetheless, prolonged prices at 20% of the current break-even budget will hurt.

One of the first levers to be pulled by oil exporting counties was the lifting/reduction of fuel subsidies.  This is broadly welcomed as it is well known that fuel subsidies create serious market distortions and come at a huge cost to other services.  

Before reforms, Egypt spent more on fuel handouts than health, education and infrastructure combined  (Robin Mills)

Egypt has relied on the largess of aligned Gulf states for financial aid for many years.  Those states are feeling a lot less rich today and the aid is drying up.  Consequently fuel subsidies are being lifted in oil importing countries also.  Once subsidies are removed, it is very hard to reintroduce them.

Prolonged low oil prices driven by visible demand destruction will lead to a massive and very real fight for ‘market share’, the start of which we are witnessing today.  Coupled with regional politics that are well beyond the scope of my commentary, low oil prices could be come extremely destabilising for the region over the longer term.  This was foreseen as early as 2012 by Chatham House and the first, and arguably the second predictions are becoming manifest.

If the oil price goes much lower, three scenarios could ensue sequentially:

  • a price war forcing prices even lower
  • a period of internal repression as revenues fail to buy compliance among populations, and
  • internal unrest among producers, which could lead to supply disruption followed by prices bouncing back.

The third point neatly summarises what oil prices won’t stay at $20/bbl over the long term.

One also has to question what happens to the ‘street’ if oil prices spike and the cost of basic and necessary fuel surges, unprotected by subsidies.    The current collapse of the oil price will inevitably lead to a price rise/spike due to supply destruction.   Over the longer time frame of a decade or so, demand destruction will be the key driver, but will have a similar effect or causing increased volatility.

If the transition to low oil prices doesn’t end in conflict then we must look to a very different future.   There will be a huge shift in the economic centre of gravity as Petrodollars – which have probably more than anything dominated world finance for the last 80 years – starts moving away from producing countries.    This is not, however, a linear equation.  As one recent headline put it “UK pensions hit by falling oil prices”…..  how does that work?

This bit of fun is for my next post.