EGEE 120
Oil: International Evolution

The Lecture for The Prize Chapter 35: Just Another Commodity

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The Prize Chapter 35: Just Another Commodity

Consider the following questions:

  • How do changing oil prices lead to inflation and recession?
  • How does the Federal Reserve typically fight inflation, and what could be the results of tight monetary policy?
  • What factors led to the downward spiral of oil prices, and what were the unintended consequences?
  • What was the rationale for the futures market, and how did it undermine the price-setting power of OPEC?
  • What were the consequences or results of oil deregulation in the US?
  • What is your view of "Oil Power"?
  • Why and how did exploring for oil in the fields give way to "exploring" for oil at Wall Street?

Oil, Inflation, Interest Rates, and Recession Following the Second Oil Shock

The end of the 70s and 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 as geology and petroleum engineering, etc. Huge sums of money were being exchanged. Oil companies began to invest in the development of other fossil fuels including shale oil technology. In 1980, Exxon bought into the Colony Shale Oil Project on the Western Slope of the Rockies in Colorado and Utah. They spent billions on shale oil development. However, in a few short years, price and demand for oil was going down, and research in shale oil subsided. This lead Exxon to terminate the Colony Shale Oil Project in May 1982. The boom that was to come to Colorado towns like Rifle, Battlement Mesa, and Parachute did not last and went bust.

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 Federal Reserve, hoping to halt the upward trend of inflation, generally resorts to raising interest rates. This makes major purchase investments (like buying a house) more costly and causes a reduction in spending, which, they hope, reduces demand, and therefore drops prices. The Federal Reserve restrictive monetary policy resulted in high-interest rates with the prime rate reaching, at one point, 21.5%. 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 had 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 (27.5 mpg) and conservation further reduced demand for oil. While demand was weakening, new technology and production sites were increasing 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, the pie itself, oil consumption, was also getting smaller from the efficiency/conservation improvements and the recession. By 1985, the US, for example, was 25% more energy-efficient and 32% more oil efficient than in 1973, and Japan was 31% and 50% more efficient in energy and oil respectively over the same period.

OPEC Begins to Feel the Pinch as Oil Becomes Just Another Commodity

Graph showing production by OPEC and Non-OPEC over time. OPEC produced less until 2007, where they consistently product more.
Plot of oil production of OPEC vs. non-OPEC nations over time.
Credit: Duncan, Richard C. and Youngquist, Walter. "The World Petroleum Life-Cycle." PTTC Workshop "OPEC Oil Pricing and Independent Oil Producers." October 22, 1998.

The collapse in oil demand, a build-up of non-OPEC supply, and the Great Inventory Dump resulted in a glut that led to a reduced call for OPEC oil by about 13 mmbpd in 1983 (43% from the 1979 levels!). In fact, by 1982, non-OPEC countries produced more oil than OPEC countries, and the spot price had dropped below OPEC prices. OPEC had two choices: cut prices to regain market share or cut production to maintain price. OPEC was forced to implement quotas on member countries to cut back production and defend their higher prices. It had now truly become a cartel, managing and allocating production and also setting prices. Even with the quotas, it was apparent in autumn 1982 that OPEC oil was still overabundant and overpriced.

The British section of the North Sea alone was producing, in 1983, more than the production of Algeria, Liberia, and Nigeria combined, and by 1983, OPEC nations, many of them economically dependent on the export of oil, were in economic decline. To compete, the OPEC countries resorted to discounting and price cutting in order to have markets for their oil. In March 1983, OPEC slashed, for the first time, its price by 15% from $34 to $29 per barrel and set a production level of 17.5 mmbpd for the entire group. Saudi was to be the swing producer to supply the quantity required to balance the market requirement. Obviously, the success of OPEC’s new system depended on the 12 members not cheating and Saudi’s willingness and ability to play the swing producer role.

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 had instead turned into a free-for-all, multitudinous buyers and sellers of “just another commodity.” While in the 1970s, consumers worried about access to oil, now producers were the ones who were worried about access to markets, and buyers expected discounts from the producers.

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 the 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. Each stage of the oil process (drilling, shipping, refining, etc.) began to be handled by a different company, and the focus shifted from long term contracts to the short term spot market. For example, while in the 1970s, 10% of the oil was traded on the spot market, more than 50% was by 1982. Loyalty had no place in the oil industry at that time. Buyers shopped for the cheapest oil they could get. In 1983 and 1984, the four Aramco companies-Exxon, Mobil, Texaco, and Chevron that had been reluctant to break the “Aramco link” acknowledged that the price for the Saudi access was too high and finally decided to reduce/break the link.

Evolution of the Oil Futures Market and Oil Exploration at the NY Stock Exchange

In March 1983, crude oil futures were traded on the New York Mercantile Exchange (NYMEX). A future contract gives you the right to buy or sell a set amount of a good at a set price & 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. There was initial skepticism and outright hostility by oil companies towards the futures market for oil. The crude oil futures market completely undermined OPEC’s price-setting powers. As seen in the course, oil price setting had gone over time from Standard Oil to the Texas Railroad Commission in the US and the majors in the rest of the world to OPEC and now to the Open market at NYMEX using computers. 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.

Photo: many men on the New York Stock Exchange Floor
Stockbrokers working at the New York Stock Exchange.
Credit: NY stock exchange traders floor by Thomas J. O'Halloran, US News & World Report from Wikimedia Commons 

As we have seen, oil was completely deregulated in the US in 1981. The deregulation, as expected, removed protection and increased competition, resulting in consolidation, spin-offs, takeovers, and other corporate changes. The 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 over-valued. 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. One of the pioneers in attempting to buy out smaller oil firms through the acquisition of their stocks was T. Boone Pickens and his Mesa Petroleum. His initial target was Cities Service of Henry Doherty, but Armand Hammer’s Occidental eventually won that battle. That set up a trend in mergers and restructuring that included Shell acquiring Belridge for $3.6 billion, DuPont acquiring Conoco for $7.8 billion, US Steel buying Marathon for $5.9 billion and Phillips acquiring General American for $1.1 billion.

Unintended Consequences of the Economic Downturn: Mexico on the Edge of a Crisis

Colored Photo Headshot of Paul Volcker
Paul Volcker, former head of the Federal Reserve Board.
Credit: Paul Volcker from Wikimedia Commons (Public Domain)

The downturn had a number of unintended consequences - falling exploration in the US, an increase in refinancing and bankruptcies among smaller companies, belt-tightening (cutbacks, hiring freezes, and early retirements) among the major companies, and interest in the stock market and mutual funds among investors. The downturn in the oil market also came at a bad time for Mexico (an oil-exporting nation), whose international debt was $84 billion from all the previous borrowing. Mexico could not even pay the interest on its loans, let alone the principal. This had been brought about by the weakening oil prices, high-interest rates, overvalued currency (the peso), unrestrained government spending, and the lack of access for Mexico’s non-oil assets due to the recession.

Mexico defaulting on its loans would cause an international financial crisis, forcing the US to lend Mexico a tremendous amount of money. To avoid exposing Mexico’s problems that would have caused a rippling effect in the financial market, Jesus Silva Herzog, Finance Minister, made secret trips to Washington on Thursday nights to work out details of a loan on Fridays with Paul Volcker, Chairman of the US Reserve and returned for social functions on Fridays in Mexico so that no one knew he had even been out of the country. To give an idea of the potential rippling effect, Mexico’s loan exposure was about 44% of the total capital of the nine largest US banks.

The initial emergency loan of $900 million was clearly not enough and led to “The Mexican Weekend” when Herzog flew to Washington on August 13, 1982, to meet with Treasury Secretary, Donald Regan, and others on a multi-billion dollar package of loans and credits and advance purchase of Mexico’s oil for the US Strategic Reserve. The deal stabilized a world financial market that was on the verge of a serious panic in August 1982. Clearly the oil boom was over, and those who over-invested were beginning to show weakness. An important lesson that came out of this was that “Oil Power” was less powerful than assumed and that oil could mean not only wealth but also a weakness for a nation. The downturn and the Mexican crisis 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.

The $2 Billion Dry Hole and the Restructuring that led to the end of Gulf Oil

In 1983, the attention of the oil industry was drawn to the Mukluk drill site, just off of Alaska. This was to be a tremendous find, a new elephant. The stock of the companies involved (led by BP, Sohio, Diamond Shamrock) increased, and a total investment of $2 billion was involved. Mukluk turned out to be dry and the most expensive dry hole! After that experience, exploring for oil went out of fashion, and buying companies with proven oil reserves was in. Why? It was all about risk factors and the expectation that prices could fall.

The restructuring in the oil industry led to Mobil acquiring Superior Oil, the largest independent for $5.7 billion and Texaco acquiring Getty Oil for $10.2 billion. T. Boone Pickens and his company, Mesa, were losing money in the Gulf of Mexico, and needed to regain some profit, and fast. Pickens decided they needed to purchase one of the seven major oil companies. Gulf Oil, built by the Mellons on the basis of the 1901 Guffey and Galey’s discovery at Spindletop, was the target due to its shaky management and falling reserve base. He began to buy portions of Gulf stock through numbered bank accounts across the US. Thereafter, Pickens began to court shareholders of Gulf, but Gulf, led by Jimmy Lee, fought back hard and beat the proxy vote in December 1893 by 52 to 48%.

Picture of T. Boone Pickens with his hands in the air
T. Boone Pickens.
Credit: Thomas Boone Pickens by Steve Jurvetson is licensed under CC BY 2.0

With Gulf’s vulnerability now exposed, Lee knew time was short, and he had to get the stock price of Gulf up quickly. He tried to bargain with ARCO’s Robert Anderson over a merger of operations, but Anderson was unhappy, and the deal was off. Clearly, the word was now out that Gulf was going to be for sale. In a three-way bidding contest, Chevron wound up buying Gulf for $13.2 billion. ARCO offered $72/share, Kohlberg, Kravis, and Roberts offered $87.50/share (56% cash + 44% securities), and Chevron offered $80/ share cash, which was the one accepted. With the deal, Gulf’s stock price had suddenly gone from $41 to $80 a share and its market capitalization up from $6.8 to $13.2 billion with a shareholder's profit of $6.5 billion. Although Pickens didn’t own Gulf, he saw this as a victory. The inefficient management had gone, and the stockholders, whom Pickens felt he represented, won out. Mesa itself made $500 million ($300 million after taxes). Pickens was given, in 1985, an $18.6 million bonus by Mesa’s board for his takeover maneuvers, making him the highest-paid corporate executive in America that year.

Pickens made further attempts for both Phillips and Unocal, and Mesa made significant profits even while losing the fight to others. The restructuring through mergers and acquisitions continued with Royal Dutch/Shell paying $5.7 billion for the 31% of Shell Oil USA it did not previously own. BP also paid $7.6 billion for Standard Oil of Ohio, Sohio. The biggest losers of the restructuring were the employees who lost their jobs, and the winners were the shareholders. Companies began to defend themselves against buyouts by buying back stocks from shareholders and closing the value gap. More money was given in dividends and buybacks to stockholders. This decreased profit and caused the number of people employed by the oil industry to drop significantly.

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. The result was a serious conflict in the two views of Europe and America on security. Europe’s focus was on jobs and domestic economic stability, while America’s focus was on the Soviet military threat. The issues at the Bonn meeting were clearly “West-West” issues focusing on trade relations among themselves. Oil and energy, the “North-South” issue, was not even on the table, as supplies were safe and abundant. The 1985 communiqué issued after the meeting did not even, for the first time, include a single word on oil and energy! Oil was now clearly just another commodity!

Yergin, Daniel. (2008). The Prize: The Epic Quest for Oil, Money, & Power. New York: Free Press.