April 26, 2018 / 1:03 AM / 3 months ago

RPT-COLUMN-Oil prices, or how I learned to stop worrying and embrace the cycle: Kemp

(Repeats April 25 column. John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, April 25 (Reuters) - “Discipline” has become the oil industry’s favourite word as it emerges from the deepest and longest downturn in a generation.

Senior executives are pledging to maintain a cautious approach to investment and spending despite the recovery in oil prices over the last two years.

Business leaders and shareholders are still scarred by the memory of project over-runs, spiralling costs and frenzied drilling during the last boom, and the painful adjustments during the subsequent slump.

Corporate leaders are under pressure to focus on returning more cash to investors rather than indulging in expensive and risky plans to boost production.

The case for a more disciplined approach has been powerfully argued by my counterpart Liam Denning at Bloomberg (“This is Big Oil’s Quarter to Lose”, April 24).

This time really will be different, according to the industry, with earnest promises to learn from past mistakes.

But there are good reasons to be sceptical.

The oil industry has been characterised by deep and prolonged boom-bust cycles since the first modern well was drilled in 1859.

Deep cycles are the natural condition of the oil industry and there is no reason to think the future will be any different.

DEEP CYCLES

Cyclical behaviour is the oil market’s most distinctive characteristic and deeply rooted in the industry’s structure rather than mistakes by its leaders.

Price cycles stem from the low price-elasticity of supply and demand, the prevalence of backward-looking expectations and behaviour, and the lumpiness of new discoveries and investments.

They also stem from the prevalence of positive and negative feedback mechanisms, which alternately amplify and dampen the initial impact of price changes.

The oil market is really multiple sub-markets for crude, fuels, refining, services, engineering, construction, drilling, skilled labour, steel, raw materials etc.

Each market is subject to its own feedback mechanisms, operating at different speeds and timescales, with constantly changing supply and demand.

Balancing “the oil market” would mean balancing all these sub-markets simultaneously.

In practice, the sub-markets are never simultaneously balanced or in a state of equilibrium except accidentally and never for very long.

STABILISATION?

Economist Paul Frankel’s “Essentials of Petroleum”, published in 1946, remains the best explanation of the oil industry’s boom-bust cycle.

Frankel noted the basic features of the oil industry made for “continuous crises” with hectic prosperity followed all too swiftly by complete collapse.

Frankel concluded the oil industry was not self-adjusting and had an inherent tendency towards extreme crisis.

As a result, he was sympathetic to the need for “leading interests” and “planners” to act as “eveners” and “stabilizers”.

Frankel urged a form of managed competition, in which oil producers would recognise their common interests and coordinate their policies at strategic level while remaining competitors at tactical level.

(I’m not sure how this distinction would work in practice. Frankel did not explain it in detail and seems to have been unsure himself).

At different times, Frankel argued that the role of adjusters and eveners had been played by monopolies such as Standard Oil, the major international oil firms, and governments, sometimes in combination.

But this was the least convincing part of Frankel’s argument. There is no evidence that any monopoly or combination of interests has ever managed to stabilise the market for long.

Even the long period of apparent stability during the 1950s and 1960s came to a dramatic end with the oil shock of 1973 (which was rooted in the long period of low prices during the previous two decades).

The price cycle cannot be tamed. Oil-producing companies and countries have to learn to ride with the volatility.

“We’ve never been good at predicting these (price) cycles, neither when they occur nor their duration. We don’t spend a lot of time even trying,” Exxon Mobil’s then-chief Rex Tillerson told investors in March 2016.

“How the future is going to look, we take no particular view on it, other than to recognise that whatever it is today it will be different sometime in the future, and after that it will be different again.”

“In my nearly 41 years (with Exxon) ... I didn’t learn anything about my ability to foresee that. I learned a lot about how you deal with it.”

INVESTMENT

The major oil-producing companies and countries are always cautious in the first stages of a cyclical expansion when memories of the previous slump are still fresh.

In the early stages of the last boom, between 2002 and 2006, the major companies were notoriously conservative about investment, worried the rise in prices would not prove sustainable.

Ironically, the slow response of investment and production accelerated the boom and pushed prices much higher than they would have risen otherwise.

But the combination of high and seemingly sustainable prices eventually triggered a late-cycle rush of investment, not just from the majors but also the independent shale producers.

The sluggish response of investment to changes in oil prices is one of the biggest causes of instability in the oil market. However, it is not clear the major oil companies could or should have behaved any differently.

If they had adopted an even more restrictive approach to investment, prices would have risen higher, providing an even sharper incentive for other suppliers to fill the gap, most likely U.S. shale producers.

The history of the oil industry is of attempts to restrict investment and production to stabilise prices. In every case, price stabilisation efforts have been undone when rival sources of supply were developed to fill the gap:

Pennsylvania. Ohio. Dutch East Indies. Romania. Burma. Russia. Texas. Oklahoma. Alberta. California. Mexico. Venezuela. Persia. Iraq. Arabia. Libya. China. Alaska. Nigeria. North Sea. Gulf of Mexico. Deepwater. Oil sands. Most recently U.S. shale.

There has never been a shortage of petroleum resources. Every attempt to restrict investment and production has failed because it encouraged the development of new and alternative sources.

RIDING THE CYCLE

OPEC and the oil majors may exercise some influence over oil prices in the very short term, but in the medium run they have proved to be price-takers, not price-makers.

If the oil majors were to attempt to be more “disciplined” this time around, the resulting rise in prices would simply accelerate the development of alternative sources of supply, as well as curbing demand growth.

The majors would end up with lower prices and a smaller market share. Much the same fate awaits OPEC if it tries to tighten the oil market too much (again).

What about control over costs? Here too the oil majors and other producers are at the mercy of the industry cycle.

Costs for everything from skilled workers and drilling contracts to steel, raw materials, seismic surveys, engineering and a host of other oilfield services are pro-cyclical.

In the aftermath of a slump, it is easy for corporate leaders to preach the need for continued cost control, but as the cycle matures and the supply chain tightens, cost pressures inevitably build.

Oilfields are a declining asset. If oil companies want to remain in the game, they must invest, accept the price cycle, and manage it as best they can.

Most oilfields will produce for decades, so producers must take a view through the cycle and accept the inevitable short-term volatility.

Related columns:

“Volatility and cyclicality in oil prices – will this time be different?”, Reuters, 2017

“Oil industry costs will rise as focus shifts to growth”, Reuters, 2017

“Persistence of instability in the oil market”, Reuters, 2016

“Why is oil market rebalancing taking so long?” Reuters, 2016

“Operational excellence becomes oil industry watchword (again)”, Reuters, 2015

Related chartbook:

“Oil prices: volatility and prediction”, Reuters, 2016

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Editing by Dale Hudson

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