The Fuse

The Failure of History: How Oil Has Entered a Brave New World

by Gregory Brew | August 13, 2019

For anyone raised on fears of “peak oil,” gasoline shortages and perpetual high prices, it seems a bit surreal that oil should be in over-supply for this long.

Earlier this year, it looked like the cycle had been broken. Now, the market seems to be slipping back into a glut. The International Energy Agency (IE) reported in July that supply exceeded demand by 900,000 bpd in the first six months of 2019, and that markets would remain in over-supply next year.

The tendency to over-produce, to fill markets with an abundance of crude and suffer through repeated boom-and-bust cycles, has been common in the oil and gas industry throughout its history.

When prices collapsed in 2014, analysts were quick to draw comparisons with past busts—most notably the “third shock” of the mid-1980s, when over-supply and artificially inflated OPEC prices sent markets tumbling.

In the past, producers have cooperated to restrict output in order to balance prices and mitigate the boom-and-bust cycle. Now, the cycle seems frozen, with a persistent glut driven largely by unrestricted production from the United States. Profits have disappointed, shareholders are frustrated, yet investment activity continues and money flows into a mounting pile of O&G projects.

It’s hard to predict what the effects on global oil will be, even in the short-term.

But now it’s a brave new world. Throw in uncertainty over demand and the crisis of climate change, and it’s hard to predict what the effects on global oil will be, even in the short-term.

From the first discovery at Titusville in 1865 through to the end of the 19th century, oil was in a constant state of instability, with frequent spikes in price. A degree of balance was brought through cartelization—by taking over domestic refining, John D. Rockefeller’s Standard Oil succeeded in stabilizing prices, until the company was forcefully dissolved by the U.S. Supreme Court following an anti-trust investigation in 1911.


Source: BP Statistical Review of World Energy, June 2016

Standard Oil broke apart, and its offspring—including the Standard Oil Company of New Jersey (Exxon) and the Standard Oil Company of California (Chevron)—constructed vertically-integrated operations that spanned the globe, encompassing productive (though declining) fields in the United States and the vast new reserves of the Middle East.

Conscious of the fact that unrestricted exploitation of Saudi, Iraqi and Iranian oil fields would depress prices and decimate profits, the majors cooperated to restrict supply—a process of oligopolistic management well documented by scholars such as Edith Penrose, Peter F. Cowhey and Timothy Mitchell.

In the 1970s, this system collapsed when OPEC succeeded in prying control over price and production away from the majors. But the OPEC partners found themselves compelled to restrict production for precisely the same reasons: allowing oil to flow freely would send prices into free-fall. With limited success, Saudi Arabia has led OPEC in efforts to control production. As the OPEC share of global supply declines, the group’s ability to influence prices has fallen, a phenomenon illustrated vividly by the “shale revolution” in the United States.

High prices in the 2000s contributed to a push by oil and gas companies to embrace new technologies—including hydraulic fracturing and horizontal drilling. The result was rising American production for the first time in decades. When prices collapsed in 2014, the companies retrenched, took on new debt, sold off assets or were bought out by the majors.

Boom should have followed bust. But the big companies haven’t seen the profits they were expecting. Oil prices have declined through 2019. Spikes in geopolitical risk, including tension in the Persian Gulf and continued instability in Venezuela, have brought volatility without shifting markets from the continued slump.

The effect of the years-long glut have been varied, to say the least. Drops in prices produced political crises in OPEC member states, including a full-blown internal crisis in Venezuela. In the United States, low prices drove smaller companies out of business: since 2015, about 175 oil and gas firms have filed for bankruptcy.

IHS Markit estimates the three majors active in the Permian—Chevron, ExxonMobil and Royal Dutch Shell—will have to invest $30 billion through 2020 to achieve their growth targets.

As independents scale back or drop off, the majors have poured money into the Permian, buying up $10 billion in acreage since 2017. Analyst firm IHS Markit estimates the three majors active in the Permian—Chevron, ExxonMobil and Royal Dutch Shell—will have to invest $30 billion through 2020 to achieve their growth targets.

Despite low prices, ExxonMobil and Chevron both have plans to boost output from the Permian Basin, the new center of U.S. oil and gas production, to 1 million and 600,000 bpd respectively by 2024.

Acting in the traditional role of swing producer, Saudi Arabia has led OPEC in cutting production, to rebalance markets. With Russian cooperation, OPEC has removed about 1.2 million bpd from global markets since 2018. But the increase in Permian output has largely negated the OPEC cuts and maintained the glut that sent prices cratering in 2014.

Then there’s the demand picture. Even amidst the financial crisis of 2008-2010, oil prices ticked upwards thanks to strong demand growth in the developing world, led by the fantastic consumption boom in China. Now, that growth is tapering off. It may disappear altogether if trade problems push the global economy into recession in 2020, as some are predicting.

In the past, companies could ride out market fluctuations, confident that with time, demand would pick back up. But renewable energy is getting cheaper, and is much more politically attractive than it was ten years ago. “A radical disruption scenario” predicted by McKinsey could bring dramatic changes in transportation, as millions opt to use electric cars.

The mounting crisis of climate change, an existential threat to the future of human civilization, has created deep uncertainty over the future of energy consumption. Pressure on the companies to scale back carbon-heavy activities and switch to clean energy has been building, and the worsening global forecast should only increase that pressure.

In more immediate terms, the experience of Hurricane Harvey, which inflicted $125 billion in damage to the Houston metropolitan area, the heart of the global oil industry, offered a threatening picture of a future dominated by increasingly violent weather and unpredictable environmental cataclysm which could directly threaten companies’ investment.

In the short-term, fears of a continued glut focus on the threat of a global economic downturn. But the picture for oil in the longer-term is just as uncertain. “Peak demand” remains a topic of considerable discussion, despite assurances that the global economy will need an increasing amount of fossil fuels for the foreseeable future. Past experience can offer some guidance, but by every indication the industry is heading into a new age, with unpredictable consequences.