Back to the Future – Can We Learn From Past Oil Cycles?

We are obviously now in a crude oil supply/demand – price cycle.  Crude prices started up in about 2004.  Prices rose fairly rapidly over 3 or 4 years from about $20/Bbl to near $100/Bbl and have stayed near or over $100 until about 6 months ago when they began to drop rapidly.  They are now around $50/ Bbl and there is much speculation on what will happen next.  Almost all of us in this country have a vested interest in what happens next –  we are either/or both, investors, work for an oil industry company, or simply a use oil & gas related energy. Because of this, most news stories, wherever found, have some report on the industry every day.  They mostly report on what happened yesterday to oil or gasoline prices and/or they have some speculation on what might happen next.  Very few, if any, provide much perspective for us to make our own assessment of what might happen next. However, one of the better articles on the situation was in the Wall Street Journal on January 14, 2015.  It was titled “Back to the Future?  Oil Replays the 1980s” by Russell Gold.  The other was an opinion article in the New York Times by Daniel Yergin on January 23rd, 2015.

I only difficulty with Russell’s article is that he did not start “back” far enough.  (If he’s 40 years old, he might remember that something happened in the 80’s, but probably not the 70’s.) The last cycle for production and prices comparable to the one we are in now started in 1973.  To understand what really happened in that cycle, I think one has to go back to the beginning, but Russell started at the end.

For a couple of decades prior to 1973, we had a stable oil price.  Production rates were controlled by the Texas Railroad Commission and other state commissions – not a totally “free market”.   Two things happened in 1973 that changed the world of oil and gas in important ways. Daniel Yergin’s  article had some history that started early enough.  He gave us an indication of what he thought needed to happen, but not much detail on how it might happen. Yergin points out that prior to 1973, the U.S. was the world’s largest oil producer.  And we were not producing at what was thought to be the maximum rate. Back about 1920, some oil industry participants thought that we had producing wells too close together and initially producing at too fast a rate.  The result was we were not recovering as much oil in place in any single reservoir as we could. So in the name of conservation, the Texas Railroad Commission and other state commission began placing allowed production rates based on an engineering calculation of a Maximum Efficient Production (MEP) rate.  The objective was to increase the total recovery of the “oil in place”.  These commissions specified how closely wells could be spaced, tracked the MEP rate for each well, and each month  determined “allowable” levels of production for each well based on purchase nominations of refiners.  The allowable was a percentage of the MEP. An allowable of less than 100% meant that we had spare production capacity.  We also had an import quota that was the maximum amount of crude oil that could be imported regardless of price.  The U.S. crude price was between $3 and $4 per barrel.  Middle eastern oil was less,  but was set by market demand which was affected directly by U.S. import quota’s.  As we used to say in the industry, the Texas Railroad Commission was in charge of production – and by default – for a stable price that was high enough to encourage some exploration and drilling – hopefully sufficient enough to cover depletion and demand growth.

Two things that happened in 1973:  The Arab oil embargo happened.  Allowable’s went to 100%, but we found out our maximum production levels would not cover our demand. We had some shortages during the embargo and after the embargo ended, we started importing more oil. The imports continued to increase for the next 40 years or so.  Prices went up in the next few years to the high $30’s per barrel and drilling rates increased rapidly in the U.S. and world-wide.  There weren’t enough rigs or people.  So costs went up rapidly as well.  Although drilling activity went up in the U.S., most large companies believed that the U.S. was no longer a place to look for large reservoirs.  There was a lot of money spent world-wide looking for oil in places not part of OPEC.   It took 7 or 8 years – much longer than most people thought – but by 1981, non OPEC production was starting to put pressure on OPEC.  OPEC agreed to cut production to support the price, but many cheated, so Saudi Arabia took the vast majority of the production cuts.  By 1983, there was starting to be some decline in oil prices, but the big drop came in 1985 where Russell picks up the story.  By 1985 Saudi Arabia had cut its production about in half.  Up to that point they had surplus cash flow, but if they went lower it would be a problem.  Instead, they opened-up the flow and took the price down from the low $30’s to under $10 per barrel.

The price did not stay that low very long.  But a price of $10 per barrel was below the producing costs of some areas such as the North Sea.  So there was an economic incentive to cut some production.  The price did not stay that low that long, and it eventually stabilized around $20/Bbl.  The $20 price was considered by most people to be the price the Saudi’s thought, correctly, would generate  enough drilling to cover depletion and demand growth without spurring another drilling boom.  We used to say that the Texas Railroad Commission had lost control to the Saudi’s.  We had a relatively stable price in the low $20’s for the next 15 or 20 years.  Drilling rates got cut steeply, but not completely.  In the U.S. we went from about 4,000 active rigs in 1981 to about  400 – 600. in 90’s.  With the growth in some world economies, – particularly by the Chinese – it appears that the price was not high enough to generate enough drilling to cover depletion and the increased demand.  So after 2004, the price has gone up significantly.  There weren’t enough drilling rigs and people to accommodate the higher level of activity as was the case in the 1970’s.  It’s taken about 8-9 years this time, but world-wide we now seem to have a surplus of production capacity again, and prices have fallen significantly. Surprisingly much of that increased production has come in the U.S. so our imports have actually fallen.

So far, this sounds a lot like the previous cycle.  It’s a shortage and lack of sufficient drilling that started this cycle.  The price probably went higher in the short run than what was needed for long-term price stability.  The time frames are not radically different during the expansion phase, it’s taken 7-9 years in both cases.  But what happens next?  There are probably a few important differences from the last cycle.  The important questions are:  Will we get back to a stable price again that will encourage enough drilling to cover depletion and demand growth in the long-term?  If so what will  that price be?  How will we get there? and when?

Daniel Yergin says that Saudi Arabia  has abdicated the role of the “swing producer” that is willing to adjust production levels to stabilize prices.  This happened he thinks at the OPEC meeting in Vienna, when the Saudi’s opposed OPEC production cut backs.  He says that the role is one they took over from the “allowables” process of the Texas Railroad Commission in 1973 and now the U. S. then becomes again the “swing producer”.  Maybe.  One problem is can the U.S. really take that on.  We’re still not self-sufficient in oil production and the Texas Railroad Commission has not issued allowables in over 40 years.  We’ve had a “free market in the U.S.”  Are we ready to go back to the mechanisms we had prior to 1973.  Could we, even if we wanted to?  Is Saudi Arabia really abdicating or are they just not wanting to be the only OPEC country really taking a hit as they were in the 1970’s?  Maybe they just understand that eventually the price needs to come down below production costs before we get back to a supply/demand balance, and that it may take less time – with less pain to them – to get there if they let the market work.  In their public statement they seem to think the long-term stable price may be in the $60-$70 range, But they may believe it has to go below that in the short run, before it can be stabilized at that level.

I tend to believe the latter possibility.  A long-term price of around $60 seems reasonable, and I think the Saudi’s would support that.  But we’re not there yet.  We had about a 15 year cycle before (1973-1988).  I see no reason to believe this should be shorter except for the Saudi position.  If it was a 15 year cycle  that was two years longer that it needed to be because the Saudi’s tried to avoid it, then this one should be about 13 years.  That would give us two or three years left before we get to a stable price.  But that’s a guess! How and when we get there and exactly where we end up is, at best, uncertain.

What do you think?



About tjc13

BE - Chem Engineering, Vanderbilt Univ, MBA, University of Tulsa - Worked for an energy and chemical company for many years and then started a management consulting business working for both for-profit and not-for-profit organizations.
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