Why this surprise?

The overwhelming consensus that lower oil prices are here to stay may not necessarily turn out to be true 

It is an unusual and dramatic event when oil halves in price in a few months. Indeed, except for the crash of 2008, it has never happened before since 1900. (It dropped by two-thirds from the end of WWI until the depths of the Depression in 1932 and it dropped 75% after the 1980 peak caused by the Iran-Iraq war and other factors, but in both cases it took several years.) This time, there we were, muddling through quietly, minding our own business, when, Bang!, it happened. Or that is how it felt to most people and most economic commentators. So what was going on? And how unexpected should it have been? 

Demand- or supply-driven bust? 

Oil is recognised as being central to our economy, yet, if anything, its historical role has been underestimated. I argued last quarter that without it our modern economy would not exist and its replacement would be unrecognisably less advanced. Given the complexity of the oil and energy industries, it is probably not surprising that the analyses available for this unique decline differ so widely. The reasons given range from the ingenious to the brutally simple. I usually have a soft spot for ingenious arguments, but for once I believe the simplest case is the right one this time: that it was not unexpectedly weak demand but relentlessly increasing US oil supply that broke the market. There is little that is dramatic about recent GDP growth or oil efficiency. Global GDP growth has been a little disappointing continuously for several years and I believe is likely to continue to be so until official expectations become more realistic. But this disappointment has been slow and steady from the 2009 economic low and many oil experts, I am sure, learned to adjust for it. Increases in the efficiency of oil usage have also been steady but unsurprising. The end result for oil usage in any case was a very boring series of small increases.

A more complicated argument that this is indeed a demand-driven crisis makes the case that we have had a sudden downgrading of long-term future oil demand. However, this does not seem to relate to recent oil consumption or future GDP forecasts. It has more to do with rationalising the recent collapse in prices in a demonstration of touching faith in Mr Market’s foresight: “the oil price has dropped dramatically and, because the market must know what it’s doing, then it must mean that there will be a future collapse in demand.” This is perhaps even more misguided than faith in the stock market’s efficiency. The stock market, as we’ve all discovered at least twice in the last 15 years, is capable of being gloriously inefficient but, compared to most commodities and oil in particular, the stock market is very efficient indeed. 

Dire demand-driven arguments 

Are there other arguments that this was a demand-driven bust? Well, I belong to the group that believes: a) in the extreme importance of oil to our past economic success; and b) that the much higher prices after 2000 were helping to steadily weaken the vitality of the growth in developed countries. But some very smart members of this group argue that so much damage has already been done by higher oil prices (and the underlying cause — depleting supplies of cheap oil resources) that total global consumer demand, squeezed by higher resource prices since 2000, is ready to implode, or indeed may have already started to implode. According to this theory, the growing weakness in global economic strength is what is driving down the price of oil and other commodities: we simply cannot afford the much higher prices of recent years, they argue.

My view is that these pessimists (or “realists” if they turn out to be correct) may well be right in the next 10 to 20 years unless we get serious about developing cheap alternatives, as discussed last quarter, and that we should be very worried about this possibility. But, in my opinion, no economic implosion is likely just yet and, even if the pessimists are right eventually, that crunch era will be ushered in by very volatile and rising oil prices, not three years of abnormal stability followed by a sudden bust! Right now the mad rush to produce fracking oil in the US (one might reasonably say “overproduce”) has given us a global timeout from the inevitable oil squeeze, which in my opinion is now likely to arrive in about five years but which, without US fracking, was already upon us. 

 Marginal pricing and volatility in commodities

Mr Market for commodities is a very wild dude indeed. Prices can move between the marginal cost of providing the cheapest next unit, in a glut, to whatever the most desperate marginal user is willing to pay in a shortage. There is no moral equivalency to that in the stock market. Stock experts may say “greed and fear” (or greed and outright panic), and it’s true that these impulses have impressively influenced the stock market on occasion, but these passions can also apply to commodities, exacerbating their unique sensitivities to imbalances in supply and demand. Commodities can also involve storage of the asset and attempts to corner the market — rather archaic these days in stocks. Most critically, politics, both local and global, can play a much bigger role in commodities, especially oil, than for stocks as we are seeing once again. 

The stress on Opec and the Saudis 

This time the stress came not from obstreperous Opec members but from the US fracking cowboys, each attempting to produce as fast as utterly possible even if they had to borrow more than their cash flow to do so. This was an avenue previously closed to most Opec and non-Opec producers alike, engineered in the US by a Fed-manipulated era of low interest rates and, for frackers anyway, available debt. Faced with the reality of the rapid rise of US fracking production and the declining share for Opec, and confronted with the possibility that at over $100 a barrel the US increases might continue at around an incremental one million barrels a day for another two or even three years, Opec, especially the Saudis, had to do some unusual calculations. The trade-offs they faced had never arisen before. This is the first time that fracking has played a major role in global production, and fracking, particularly in the US, has a feature totally unlike other oil: its production can be turned on and off far more rapidly than conventional oil. It is easy to understand the Saudi’s reluctance to cede market share to the US frackers for several years into the future, perhaps down to half of their usual production. They may believe that: a) lower prices can be maintained for a long time, if not forever; and b) that at such lower prices much of US fracking oil will never be produced.

Where were we analysts? 

I believe the reason for the glut is not complicated: an unprecedented and largely unexpected series of increases in US fracking production combined with a refusal on the part of Opec to cut back. The alternative reasons that are given are, in my opinion, over-engineered. The problem I have is in understanding why this oil glut came as such a shock. The month-to-month gains in output from fracking could be studied. Yearly productivity increases per well were substantial — over five years, output from new wells in their first year more than doubled in the Bakken — but productivity moved up pretty smoothly month-to-month. The number of rigs being used could be followed. The steady increases after mid 2012 were thus in a sense unremarkable, just a continuation of trends in play.

Both the rig count and the increase in productivity rose steadily so that the year-over-year increases remained quite smooth for over two years. If kept up, such large and steady increases would have to break the market price, ex some offsetting reductions, and the rising oil in storage could be measured showing the increasing pressure on the system. Demand was also reasonably predictable, coming in steadily a little less than earlier expected, but not much less. Clearly, though, global oil demand was not growing fast enough to absorb the new US fracking increases indefinitely. We were rapidly approaching a binary choice: either Opec, particularly Saudi Arabia, would decide to lower its production or the oil price would break. Only those utterly confident in the Saudi’s willingness to cut should not have been nervous about the price, and it is hard to say where such certainty would have come from. 

The correct strategy for investors in such a situation would probably have been to buy put options. Then if the probability of a major break (over 10%) was more than 1 in 15 you would have made money. My motto in investing is always cry over spilt milk, for analysing errors is how you learn almost everything. And, yes, my major regret for 2014 is, “How on earth did I miss this!” A combination of laziness and distraction is my lame excuse. What is yours?

Looking ahead 

So what happens now? We originally heard a brave story of how increased fracking production would cheerfully continue full steam ahead, even at prices below $40 a barrel. This is of course nonsense: it was not clear that the US frackers were making very good money collectively at $100 a barrel. Now, at $32, their cash flow drops by $68 a barrel (less taxes, etc.) and we are meant to believe that they are merely winded. Rigs are being rapidly withdrawn as I write. What is not realised yet, although very shortly will be, is how rapidly fracking wells deplete. Even some of the recent impressive improvements in “productivity” have been moving more of the total output into the first year. Up to 65% of all of the available oil is now often delivered in the first year! Even in the heyday last July, 75% to 80% of all new production in the Bakken was needed to offset the decline from existing “legacy” wells. It could be worked out that daily production would start to decline with only a 25% reduction in oil rigs at work, a level we are rapidly approaching. Thus, at current or lower prices, Bakken production should turn down by June and possibly by the end of the first quarter.

Unlike fracking, which takes days to adjust, old-fashioned oil, which is increasingly deep offshore or in countries that we can all agree are more difficult to operate in than, say, North Dakota, can take 5 to 10 years (and occasionally 15) before a planning dollar becomes gas in the tank. Spending cuts, therefore, will echo into the quite distant future as reduced oil production for which there will be no quick fix, for by then any increases from fracking will be distant memories. And this is a key point: US fracking is the only important component of global supply that can turn up almost immediately by bringing in new rigs and drilling wells in under two weeks, adding 20-30% to production in a year as it did for each of the last two years. It is also the only important component that can turn off quickly by depleting almost completely in three years. 

As with Alice’s Red Queen, if you pause for breath in fracking you go backwards: more wells must be drilled all the time to even stay still as the wall of rapidly depleting wells builds up behind you. Nothing like this has ever been experienced before so drawing wrong conclusions, as if the traditional data applied, is particularly easy. 

The new oil balance 

Lower oil prices and much reduced capex will guarantee that oil from fracking will start decreasing this year and that the supply of traditional oil will be less than it would have been. Indeed, at recent prices very few, if any, new drilling programs will be started, and a mere three years later at current prices, 80% or so of Bakken production would be history. But right now we have a substantial excess of production, and oil demand is notoriously inelastic to price in the short term — people will not be leaping into their cars to celebrate lower gas prices. But with time they may drive an extra 1-2% percent here and elsewhere and the excess will slowly clear: possibly by mid-year and almost certainly by the end of next year. 

After supply and demand come into balance, the price initially is likely to rise slowly, held in check by the increasing amounts of US fracking oil that can be profitably produced at each new higher price level. It is this rapid response rate that will make the frackers the key marginal suppliers. This is a sensitive and, I believe, unknowable equation as to precise timing, but this phase will likely end only when fracking production, even at much higher prices, tops out, as it most likely will in the next five years. After that, I believe the equation will revert to the relatively more stable and more knowable one of the 2011 to 2013 era, in which the price of oil will be the full cost of finding and developing incremental traditional oil, which by then is likely to be over $100 a barrel. (In the interest of full disclosure I personally have been and will continue to be a moderate buyer of oil futures six to eight years out, for reasons that should be clear from the above. It should also be clear that such a bet can lose easily enough.)

Why the Saudi’s decision may be wrong 

To move back to Saudi Arabia’s decision not to cut back, one thing they may have overlooked, as most of us investors do, is unintended consequences. It is important to recognise in this case that the short-term benefits are spread widely and thinly, but the negatives are concentrated painfully and thus may destabilise the system. The economic pain from the lower oil price on Venezuela, Iran, Nigeria, Libya, Russia, or the Gulf States might set off regional political disturbances or provoke some rash action. Their debt problems combined with those of overleveraged oil sector companies might set off global financial problems. Major shocks like this to the status quo are just plain dangerous, and Saudi Arabia, which loves stability much more than most, may come to regret not having sucked up the pain of selling less for a few years. Cutting back up to half the Saudi oil would have certainly cleared the market for several years and very probably until US fracking supplies peak. Even at its worst for the Saudis, in four or five years isn’t selling half the oil at twice the price a real bargain? All of the fracking oil that can be produced for under $100 a barrel will almost certainly be produced eventually anyway. Current events are very probably merely postponing the production for a while. 

The same goes for the bankruptcy of some US oil companies, whose properties will just be taken over by stronger players. Neither of these events appears to be of any longer-term benefit to Saudi Arabia or Opec in general. Would it not have been better for the Saudis (and Opec) to let the US fracking industry unload its easy production as fast as possible, peak out in three to six years, and then leave the Saudis firmly in the saddle as the marginal producer once again? If I were on the Saudi long-term planning committee that would definitely have been my vote, especially with the recent passing of King Abdullah, whose successor might not be as careful, generally successful, or as lucky as his predecessor.

Caveat lector 

My analysis is based mostly on official data. The Saudis, however, may believe that US fracking production will be substantially longer-lived and have a higher peak production of, say, 9 or 10 million barrels a day in seven or eight years. At such levels the Saudis would realise that they could not absorb it all. If such a view turned out to be correct, then the Saudis have probably made the right decision. Holding back their production for so long would also have run a high risk beyond eight years that electric cars will have begun to really change the game. The good news is that most of these details will be revealed in time. I can’t wait. In the meantime, I think the odds are with me. 

Edited excerpts from GMO's quarterly letter for Q4CY14