The Fuse

Bob McNally: The New Oil Market Paradigm

by Leslie Hayward | May 31, 2015

HAYWARD: You made the call very early, before the group’s meeting in November, that the Organization of Petroleum Exporting Countries (OPEC) wouldn’t cut its oil production quota, thus shifting responsibility to high-cost producers to balance the market.

This is obviously a massive departure from the past, when there was almost always some central force balancing the market, and we’ll talk through those issues in this interview. But first, why weren’t you surprised by the outcome?

MCNALLY: In my experience in oil markets, every 5-7 years there’s usually a surprise that reveals a big forest that many tree watchers are missing.

Ten years ago, the first big surprise was the realization that the era of easy oil was over. Everyone expected that oil production outside OPEC would surge in response to the quintupling in oil prices, as it had thirty years before. Instead, non-OPEC supply growth flat-lined. This triggered another rash of “peak oil” fears, but in fact it simply demonstrated that the era of easy and cheap oil was over.

The second big surprise was about five years ago, and that was the shale oil boom in the United States. Nobody saw it coming. Shale oil ramped up just in time to offset large disruptions from Libya, Iran, and elsewhere. Shale oil did not loosen the oil market or cause oil prices to fall below $40, but it did prevent another huge price spike into the mid-$100 range.

Now, we are in the midst of the third big surprise—that Saudi Arabia is no longer willing to play the role of swing supplier in the market.

Has Saudi Arabia surrendered its role as market manager before?

This is not the first time the Saudis have grown weary of this responsibility. During the oil supply glut in the 1980s, they steadily reduced their production from 10 mbd to 2 mbd as their friends within OPEC as well as new competitors outside OPEC—like North Sea producers—were increasing production. Finally in 1985, frustrated with playing the swing producer role and surrendering market share to support oil prices, Saudi Arabia abruptly reversed course, unleashing a gusher of new supply, flooding the market and driving an oil price collapse.

The Saudi’s move in the 1980s to unleash a gusher of supply slowed investment in oil fields all over the world, while triggering a price decline that helped to extend the Reagan-era economic boom and bankrupt the Soviet Union.

The Saudi move slowed investment in oil fields all over the world, while triggering a price decline that helped to extend the Reagan-era economic boom and bankrupt the Soviet Union. The rest is history. Following the events in the 1980s, they arguably reasserted control over the oil market in the 1990s. The question on everyone’s mind now is whether the current situation is just a temporary tactical shift on the part of the Saudis to teach a lesson to the other OPEC countries while tapping the brakes on U.S. shale supply or whether this is a more permanent change.

For the sake of argument, let’s assume that Saudi Arabia and OPEC are permanently relinquishing their role as market manager. Can you provide some historical context for why this role has been so important in the past, and how we’ve moved from one market manager to another?

The main problem that has afflicted the oil industry—as well as governments—has been the tendency of oil prices to gyrate wildly in boom-bust cycles. Bottom line, the oil industry doesn’t handle surpluses well. The short explanation is that oil is inherently insensitive to price changes on the supply and demand sides. Thus, when a surplus develops or demand outstrips supply, prices tend to move sharply.

Since the beginning of the oil industry in 1859, there have been three supply managers who attempted to stabilize prices by controlling supply side choke points—refineries, pipelines, or more often than not upstream producing fields.

The main problem that has afflicted the oil industry—as well as governments—has been the tendency of oil prices to gyrate wildly in boom-bust cycles.

The first was J.D. Rockefeller and Standard Oil. Rockefeller was appalled by the boom-bust volatility of those early decades so he forcefully took control of the oil market, which was almost entirely based in the United States at the time. He brought stability to chaos in the oil fields by taking control of the transportation “choke points” in the oil supply system—the pipelines, the trains, and the refineries–though he eventually integrated upstream and owned fields. Rockefeller’s Standard Oil trust enforced price stability, which enabled the industry to evolve from a substitute for whale oil in lighting into the dominant fuel for new motorized transportation. However, it also enabled oil to grow into a vital global commodity, for which boom-bust pricing was unacceptable to industry and to governments who had begun to cherish oil for economic and national security reasons.

Standard Oil was weakened by competitors but ultimately dismembered during the Progressive Era in the early 1900s, when trust-busting was en vogue. With Rockefeller’s empire dismantled, the wild boom-bust period returned after World War One. “Peak oil” fears from the end of the war through the early 1920s gave way to a glut as massive new fields were discovered—notably those in Oklahoma in the mid-1920s and then the monster “Black Giant” field in East Texas in the early 1930s.

Domestic oil producers (such as the Seven Sisters), major international oil companies, and national powers like the United States, UK, and France were appalled by the price volatility. States like Texas and Oklahoma began regulating production to attempt to balance demand and stabilize prices (though they justified regulation on the need to prevent “waste”).

The Texas Railroad Commission was the most effective oil market manager in history. The stability of oil prices in the mid-century was due to Texas utilizing its spare capacity, which at times equaled up to 30 percent of production capacity.

Out of that came the most effective oil market manager in history—the Texas Railroad Commission. The Commission held back production, and maintained spare capacity. OPEC and Saudi Arabia basically copied from the Texas Railroad Commission. After Texas began regulating output, the number and amplitude of price changes dropped sharply compared with the years before. For evidence of the Texas Railroad Commission’s impact, look at 1956 and 1967, when there were major oil disruptions as a consequence of two Arab-Israeli wars. History has forgotten these disruptions because there was no major price spike. The stability was due to Texas utilizing its spare, which at times equaled up to 30 percent of production capacity.

But then came 1973. Another Arab-Israeli war caused major disruptions—only this time, prices skyrocketed, Americans were stuck in endless gas lines, and we remember it to this day. Why was this different from 1956 and 1967? Again, spare capacity. In 1972, the year before the disruption, Texas ran out of spare and with it, the last vestiges of control over prices. This was also the beginning of the era of OPEC as global market manager.

These events are critical to understanding our current situation. In 2008, Saudi Arabia chose not to act as a market manager, but unlike last November or during the 1980s, rather than failing to curb supply, it failed to prevent oil prices from soaring because it had run out of spare capacity during peacetime—just like Texas in 1972.

Saudi Arabia lost control in 2008 like Texas did in 1972: Each ran out of spare capacity in peace time and was unable to prevent massive price spikes. In 2008 Saudi Arabia was unable to prevent oil prices from soaring to $147 per barrel, contributing (along with the financial collapse) to a Great Recession and demand collapse. Oil fell to $33 in six months. Recessions are an effective if brutal way to balance the oil market. As demand quickly imploded, prices crashed.

So, for Saudi Arabia, 2008 is somewhat analogous to 1972 for Texas—the moments in history when the spare capacity managers “lost their mojo.” Without spare capacity, there’s no power to cap the price. And without a willingness to cut in weak market, there’s no ability to put a floor under prices. In 2008, the Saudis were unable to put a ceiling over prices, but now they are unwilling to put a floor under prices. Thus, they are no longer serving as market managers on either end.

How much spare capacity does Saudi Arabia currently hold? How much does the market need?

By historical standards, oil prices have tended to be more stable when spare capacity was at least 5 percent of total oil market demand (often it was much larger) and ideally few disruptions. In today’s market, that equates to 4-5 mbd of spare.  Even the most generous estimates are well below that level, and actual and threatened disruptions abound.

It has only about half that amount at best and likely no more than about 1 mbd.

So now we understand why Saudi Arabia doesn’t have the capacity to keep prices from soaring. But let’s also explore why it now won’t it put a floor under the price.

I think there are three reasons.

The Saudis have post-traumatic stress from the early 1980s, when they played the sole swing supplier role and cut production from 10 mbd to less than 2 mbd.

The first is that they have post-traumatic stress from the early 1980s, when they played the sole swing supplier role from 1982 to 1985, cutting production from 10 mbd to less than 2 mbd. They don’t want to repeat the experience, yet recent multiyear oil balances implied that is exactly what they would have had to do: Cut production and surrender market share to other producers inside and outside OPEC.

The second reason is that their strategic adversaries—Iran, Iraq, and Russia—also have grand plans to increase their supply through 2020 and compete head-to-head with Saudi Arabia for buyers, especially in the growing Asian market. They are more than commercial rivals, they are also geopolitical adversaries. For the Kingdom to cut in the current market would basically mean propping up prices for their enemies.

I think it’s a myth that the Saudis hate shale oil.

Finally, reason number three is shale oil, which they tend to regard as a compulsory, quasi-member of OPEC. I think it’s a myth that the Saudis hate shale oil. I think they love it, because it can increase and decrease fairly quickly. They are thinking to themselves, “The Americans are here, they can come online in a few quarters, maybe they can also decline fast to balance the market….why don’t we let the Americans do the swinging, not only up but down?”

But realistically, are U.S. shale producers capable of playing this important role?

The real game changer today is not the boom in U.S. oil supply—it’s low spare capacity. Shale oil is flexible, but not as flexible as Saudi supply, so it will reduce but not eliminate price volatility.

Low spare capacity signifies the absence of a supply manager, and that means bigger price swings when fundamentals are unbalanced. As long as Saudi Arabia cannot swing up to cap prices when markets are tight (see: 2008) or will not swing down when markets are loose (see: now), oil prices will be prone to spikes and collapses, respectively.

As for U.S. shale, consider the following. By definition, spare capacity is supposed to come online in 30 days and be sustainable for 90. U.S. shale is not fast or responsive enough to meet these requirements. Production adjusts over months to quarters. Oil prices are low and have been for a while, but U.S. shale production has proven itself to be remarkably resilient. We haven’t seen any notable production declines yet, and we don’t even know how far it will drop.

Still, shale is more responsive than other sources of oil, such as Canadian oil sands, enhanced oil recovery projects in large mature fields, and offshore drilling. These types of projects have long lead times, and because of the high up-front but lower operating costs, it rarely makes sense to interrupt production during a price downturn.

We are likely to become reacquainted with the downsides of not having a supply manager.

So the amount of price stability that more flexible shale brings to the market depends on your perspective. If you are an oil company or World Bank economist, and you are concerned about oil prices on the scale of quarters to years, shale will smooth out some of the volatility of the market relative to what it otherwise would have been. Inventories can also smooth out supply-demand imbalances to some degree.

But for industry, governments, and consumers living in the day-to-day, oil price gyrations arising from supply-demand imbalances and the absence of a swing producer are likely to be jarring and unsettling.  It makes planning nearly impossible for all the industries and government agencies that are exposed to oil prices, from car makers to Pentagon planners and central bankers.

We are likely to become reacquainted with the downsides of not having a supply manager for a commodity that a critical input for industrial production, consumption, and defense and yet is prone to violent instability that shale will mitigate but not suppress.


  1. Harold York says:

    Who is Bob McNally? I’ve heard of him, but there is none of his background in the article so it’s difficult for most people to assign any credibility to his thoughts. Something you may want to consider for future postings.