Chapter 35: Just Another Commodity

Still within the same decade of the 70s, we see another oil shock. The Second Oil Shock saw oil prices skyrocket to $34 a barrel, and the price of everything connected to oil also shot up - drilling land, real estate in oil cities, graduates of oil-related disciplines such as geology and petroleum engineering, among other things. Although large sums of money were being exchanged, oil companies began to invest in the development of other fossil fuels, including shale oil technology. This diversion to other fossil fuels was short-lived as prices dropped again. Short-lived for now, in that we shall see later the investment in shale gas that transformed the US’s role in the global market.

As the price of oil increased, so did the price of outputs that required oil as an input. This, as we know, causes inflation. The combined effect of the reduced spending power and the tight monetary policy (high interest rates brought on by high inflation), both caused by the high oil prices, led to a deep global recession. America actually hit the “Double Dip” recession in the early 1980s, with the two bottoms being in 1980 and 1982.

Developing countries were debt-laden and, with the markets for their goods hit hard by the recession, went into economic decline, reducing their demand for oil. Thus, the recession halted the increasing demand for oil. The increasing oil prices also forced a change in the dependence on oil through increased demand for coal, nuclear, and liquefied natural gas (LNG) in electricity production. Increased energy efficiency and conservation further reduced the demand for oil. While demand was weakening, new technology and production sites were increasing the supply of oil available outside OPEC. There was major new production in Mexico, Alaska, the North Sea, Egypt, Malaysia, Angola, and China. Clearly, not only was the share of the energy pie declining, but the pie itself, oil consumption, was also getting smaller from the efficiency/conservation improvements and the recession. OPEC learned the hard way that they were no more immune to the whims of the marketplace than anyone else. Reduced demand, other sources of oil and gas, and general economic woes force OPEC into a corner. Even with attempts to cut production, set quotas, and alter prices, OPEC oil was still overabundant and overpriced.

There had clearly been a major transformation of the oil industry as the oil industry’s domination by large, integrated oil companies had broken. It was at this time that oil became “just another commodity.” Where the industry had been dominated by large integrated suppliers before, traders or ‘commercial people’ now ruled the market. With nationalization, and countries assuming ownership of the oil resources, the links that tied reserves to particular companies, refineries, and overseas markets were severed, and the oil companies, having lost their integration, became buyers and traders, just as commodity-style traders.

In March 1983, crude oil futures were traded on the New York Mercantile Exchange (NYMEX) for the first time. A future contract gives you the right to buy or sell a set amount of a good at a set price and date in the future. It was to minimize the risk from the volatility and uncertainty in the spot market, as it allowed one to lock in a price or buy at some month in the future at a specified known price. While decades earlier, the benchmark price was set with Arab Light as the marker crude, now West Texas Intermediate was used to set the benchmark price.

Oil was completely deregulated in the US in 1981. Deregulation, as expected, removed protection and increased competition, resulting in consolidation, spin-offs, takeovers, and other corporate changes. Overcapacity and decreasing prices also promoted consolidation, shrinking, greater efficiency, and greater profits. Companies started to evaluate the value gap, the difference between a company’s stock and the value of its oil and gas reserves of other companies, which gave a measure of whether the company was under or overvalued. With oil heavily traded in futures markets, many firms attempted to increase their stock by buying out other, undervalued oil companies.

Many smaller oil companies were bought out by larger ones, as it cost more to add a barrel by exploration than to buy the assets of an existing operation. Thus, it was cheaper to “explore for oil on the floor of the NY Stock Exchange” than to do so from the topsoil of Texas or under the seabed of the Gulf of Mexico.

The downturn in the industry and the near bankruptcy of Mexico clearly demonstrated the interdependence of oil and global finance. It should be pointed out that the downturn did not only affect nations but also jeopardized the integrity of the interconnected banking system, especially in the US, leading to the huge 1984 $13.5 billion Federal bailout of Continental Illinois, the largest bank in the Mid-West and the 7th largest in the US.

As we enter the early and mid-1980s there is a massive restructuring of the industry in terms of companies with mergers everywhere! The companies had to reposition to adjust to the fact that exploration was just too costly and risky, and there were options of buying ready-made reserves. At the national government level, at the May 1985 G7 meeting in Bonn, the main themes were free-market politics, deregulation, and privatization. Instead of inflation and recession, there was now a booming/vibrant economy and the bull market that was not being fueled by increased demand in oil.