The Oil Price: how low is low?

With West Texas Intermediate (WTI) and Brent close to their January 2015 lows some readers are wondering how these lows compare with historic lows when the oil price is adjusted for inflation (deflated). BP just happen to provide an oil price series that is adjusted for inflation (Figure 1). The data are annual averages and based on Brent since 1984. Annual averages conceal the extreme swings in price that tend to be short lived. At time of writing WTI front month future contract was $44.42 and Brent front month future was $49.92.

Figure 1 The blue line gives the annual average oil price (Brent since 1984) in money of the day and the red line adjusted for inflation expressed in $2014. Three large spikes in the oil price are evident in the 1860s, 1970s and 2010s. It is notable that the magnitude of each spike is similar, of the order $100 to $120 (adjusted to 2014 $). The 1860s and 1970s spikes were followed by long bear markets for the oil price, lasting for 110 years in the case of 1864 to 1973.

To understand what was going on 1861 to 1973 I suggest readers read The Prize: The Epic Quest for Oil Money and Power that earned author Daniel Yergin the Pulitzer Prize. It is a tremendous read. Most of us are however, more interested in how today’s prices compare with recent slumps, most notably the slump of 1986 and 1998 (Figure 2).

Figure 2 The main events, Acts 1 to 6, are described briefly below.

To get straight to the point. Brent will need to fall below $30 to match the lows seen in 1986 and to below $20 to match the lows seen in 1998. WTI in particular is trading close to its support level of $43.39 marked on 17 March 2015. If traders push the price below that level then the price could fall a lot lower for a brief period. At the fundamental level, supply and demand need to be rebalanced and the main problem is over-supply of LTO from the USA and of OPEC crude depending upon which way one views the problem. The recent price action since September 2014 has been brutal on producers but not yet brutal enough to remove the 3 million bpd over supply from the system. I do not believe that the white knight of increased demand is about to gallop over the hill and therefore see a risk of substantially lower price in the months ahead. Colleague Arthur Berman has a somewhat more upbeat perspective.

Historic Fundamentals

The large scale structure of oil price history is shaped by supply and demand driven by both political dimensions and industry action and innovation. The main landmarks are:

1. The 1973 Yom Kippur war followed by the 1974 oil embargo. The amount of crude withheld from market by OPEC was relatively small (Figure 3) but was sufficient to cause the first oil price shock.

Figure 3 Oil exports for selected OPEC countries based on BP 2014.

2. The 1979 Iranian Revolution followed by the 1980 Iran-Iraq war led to the second oil shock. The price reaction at this time did not reflect the fundamentals of supply and demand and gravity soon took over sending the price down again in the years that followed together with OPEC market share.

3. The 1986 slump was caused by OPEC reasserting its authority and trying to reclaim market share that led to a prolonged bear market that culminated in 1998 when the world was awash in oil.

4. The low point since the first oil shock was marked by $10 oil (money of the day) in 1998. I remember it well since I was running an oil related business at that time. This heralded in a new era for the industry that went through a massive restructuring with many household names being swallowed up by the super-majors.

5. The commodities bull run that began around 2002 that lasted to 2008 or 2014 depending upon one’s perspective had complex reasons from a perceived peak in conventional oil production, the Chinese industrial revolution, expansion of debt, zero interest rate policy (ZIRP) and bubblenomics. Rune Likvern gives a good account of the links between the oil price and economic policies.

6. The 2008 financial crash brought an end to phase 1 of the bull run that was re-inflated by OPEC cutting supply and QE blowing more liquidity into the bubble until 2014.

Rune argues that an end to QE in the USA is implicated in recent global currency adjustments and the rout of the oil price and that is surely part of the story. But the OPEC policy of maintaining market share and over supply of either LTO or OPEC crude have also played a prominent role in Act 7 that is still being played out and still has a way to run before a new market equilibrium is reached.

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8 Responses to The Oil Price: how low is low?

  1. Rune Likvern says:

    Euan, thanks for a nice post.

    To my understandings fundamental oil price movements become a philosophical discussion about causes and effects.

    Money is what connects sellers and buyers. Credit/debt acts as money. Credit comes first, then demand (one cannot demand [pay for] a product/service if one cannot pay for it).
    The monetary policies (low interest rates, QE) stimulated growth in credit/debt. This supported demand and prices (also for oil).

    A lasting period with high oil prices stimulated the debt fueled development of costlier oil based on the perception that consumers could pay for the costlier oil (thus retire the oil companies’ debt).
    At some point supplies overwhelmed demand/consumption and the market laws of price settlements kept working.
    Increased supplies just made the price decline deeper and likely longer.


    The difference is total global credit/debt levels and little room left on consumers balance sheets to take on more credit/debt.

  2. Javier says:

    What we should ponder about is that for almost 20 years, between 1986 and 2004, oil price was at an average of 35 $ in 2014 money. This was only 10 years ago. Now after one year at an average of 60 $ this price is creating a huge stress in essentially all producers.

    This demonstrates how quickly we have reached a situation in which the price that producers require is higher than the price that the global economy can afford. A situation that predicts periods of supply destruction followed by periods of demand destruction as the price moves from demand side to supply side.

    Peak oil is coming not due to insufficient reserves, but to elevated cost of production in remaining reserves.

  3. Euan Mearns says:

    18:15 here in the UK and I see that WTI has just busted its support, down 4.1% to $43.11 on the front month. I think its time to hold onto your hat.

  4. Karl-Heinz Dehner says:

    As for for the drop of oil prices in 1997/98, it is well understood that the decline was initially caused by the Asian crisis of 1997, which reduced the demand for oil. But additionally at that time a strong El-Nino came up.
    A strong El Nino leads to significantly higher winter temperatures in the midwest and northeastern United States. Correspondingly lower is the need for heating and thus the consumption of natural gas. Between October 1997 and February 1998, the price of natural gas halved from four to two US dollars. The lower heating demand also had a corresponding impact on the oil price.
    According to the predictions of the NOAA the current El Nino is likely to be as strong as the extreme El-Nino events 1997/98 and 1982/83. Also in 2015, the Asian economy looks to be in poor shape. Maybe the story “Asian crisis / El-Nino” is repeating itself?

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  6. Keith says:

    Although low interest rates / QE policy was implemented by USA, China UK and recently EU, with a view to inflate the markets, finally it is deflationary, as cheap money allows too much supply for demand.

  7. Stuart says:

    It’s not just about oil any more.

    As the Fed moves to tighten, the USD is going to strengthen which will drive all commodities down further and by extension drive down all commodity currencies. This sets in motion a virtuous circle for USD and a vicious circle for commodities and emerging market currencies. Every time the Fed adds 0.25% the dollar will rise and all else will fall.

    We are likely to see a big flight to safety (USD), emerging markets are going to be drained of all this cheap credit and capital and the U.S. will begin to export the 2008 depression that never happened.

    Most of the surplus capital that will flow into the U.S. will end up in U.S. treasuries, just as the Federal Reserve looks to exit/reduce their huge UST holding.

    Rebalancing of the oil price is going to come from supply destruction via non-replacement, the only bullish thing here is that neutral replacement rates are much higher today than they were in the 1980’s, so supply destruction should happen faster than it did following 1986.

    The only option the big oil exporting countries have to reassert a higher oil price sooner is to turn hostile on one another. Pipeline sabotage might become common.

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