The price of oil
Ultimately, the price of oil is determined by supply and demand. What is special about the price of oil is that there are, in theory, multiple equilibrium prices. This is because much of the supply is linked to a state budget. Where normally supply goes down when the oil price goes down, there are countries that in the past actually started pumping more oil to still realize the same revenue. Knowing that the final price is determined by the marginal buyer and the marginal seller, identifying these two parties, is essential to predicting the price of oil.
In 2014, the price of oil halved after a major transaction between the marginal buyer and the marginal seller. At the time, the marginal buyer was China and the marginal seller was Russia. In February of that year, the conflict between Russia and Ukraine began. Russia did not want to be too dependent on revenues from gas and oil exports to Western Europe in light of European sanctions. In May of that year, a deal worth $400 billion was signed with China. China took advantage of the situation and only had to pay half the market price. In the following months, the energy market adjusted to this new reality. For a long time, an oil price of $50 per barrel was a ceiling rather than a bottom.
Since the Great Financial Crisis, U.S. oil production has increased from about 5 million barrels per day in 2008 to a peak of 13 million barrels per day in 2019. That is higher production than Saudi Arabia or Russia. This was made possible by the Federal Reserve’s monetary policy, which lowered the cost of debt, and by innovations such as horizontal drilling and fracking. Those innovations were a direct result of the high price of oil before the Great Financial Crisis. Normally within OPEC, Saudi Arabia is the marginal seller, but the Saudis feared competition from U.S. shale farmers and pumped as much oil as possible to thwart U.S. oil farmers. Given rising U.S. production, they have not succeeded. Because of the reasonably steep learning curve, it turned out that the costs of the unconventional way of oil extraction could be lowered much further than expected. From now on, the United States was the marginal seller of oil, and the power of OPEC, Saudi Arabia and Russia broke down empty.
At the start of the corona crisis, OPEC + Russia reduced production by 10 million barrels per day. That was the largest reduction in oil production ever. In theory, a united cartel is capable of doubling the price of oil with a small reduction in production, but that unity sometimes wants to be lacking. Not this time. Meanwhile, oil production outside OPEC is under pressure. As part of the energy transition, more and more parties are demanding that oil companies stop investing in new production. Central bankers are warning commercial banks to stop lending money to oil companies because of the risk that not all oil will be pumped out of the ground anymore. Sustainable investors are demanding that oil companies use their cash flows to invest in alternative energy. The valuation of oil companies today is much lower than energy companies that have made the transition to alternative energy, a financial incentive for oil company executives to make the same transition. Otherwise, they will be stopped by a stray judge. Furthermore, last year’s extremely low oil price caused many long-term investment projects to be canceled. The best cure for a low oil price is still a low oil price.
Despite the higher oil price achieved by OPEC, production outside OPEC is now barely rising. Still, the production is 2 million barrels per day lower than at the peak of 2019 when the oil price was lower. In fact, it is likely that production will shrink in the coming years due to the lack of new investment. Meanwhile, oil demand is again rising toward 100 million barrels per day, equal to pre-Corona demand. A year from now, oil demand is likely to exceed global potential pumping capacity. That’s the first time in 160 years of oil market history. It is striking how much is being shouted about the energy transition when it is simply not visible in oil demand. Low investment outside the OPEC area will increase OPEC’s market share from 37 percent today to 52 percent in 2050. A cartel that gains more power can only mean one thing: rising prices. At the beginning of this century, production in non-OPEC countries also fell, with the result that OPEC’s increased power allowed it to quadruple the price of oil from $35 a barrel to eventually $145 a barrel. After all, OPEC oil’s biggest competitor is non-OPEC oil.
Due to the climate crisis and the energy transition, analysts seem convinced that the demand for oil will fall quickly. This is not or perhaps not yet visible in the statistics. If capacity limits are reached in a year’s time, a new oil crisis is even imminent. Even in the two oil crises of the 1970s, there was always sufficient production capacity. In the previous oil-bull market that started in 1999, oil prices rose from $11 to $145. When participants in the oil market realize how close demand has come to maximum supply, the slightest disruption can cause a rapid rise in oil prices. This could be Iranian-Yemeni missiles fired at Saudi oil installations, but a cold winter could also be enough to cause oil and gas prices to rise sharply. Then there will be no more marginal sellers, only marginal buyers.