More oil shocks, more conflict in the Middle East, and more price volatility characterize the period covered by this lesson. We also see major restructuring of companies with many mergers, some quite significant. Permeating this period, and in truth, most of the oil industry’s history, is the fear of running out of oil. The fear of our running out of oil or our having peaked in oil production has always occurred after major oil events such as World War I, World War II, the oil crises in the 1970s, and the new oil shock of 2003-2008. Interestingly, each time, more oil was found in new areas using new technologies, and a new surplus evolved after the 2008-2009 recession. All the data suggests there are sufficient oil resources underground. However, there are a number of constraints and challenges in getting them out. The first is the above-ground risks that can deter development and lead to supply and demand imbalance. Such risks may involve geopolitics, costs, government and company decisions, and restrictions on access and investment. The second is the increase in nontraditional or unconventional oil from ultra-deep offshore waters, oil/tar sands, shale oil, and natural gas liquids (NGL). Third, is the frightening sheer size of the potential demand of China and India and the challenges posed in meeting that potential demand.
As we wrap up our journey through The Prize, we learn that the rush for oil has not stopped since Pennsylvania in 1859. Since then, oil has had the ability to make and break nations, whether in war or in peace. It has also brought the best and worst out of society and produced booms and busts. Oil’s central and strategic role in national politics, economy and strategies, geographical distribution, and recurrent patterns of crisis continue to make it a problematic commodity. Oil powers our daily life, gives us our daily bread, and fuels our global struggles and economy. The fierce search for oil and its riches and power will continue as long as the hydrocarbon man is addicted to it. That power, however, comes with a heavy price.
By the end of this lesson, you should be able to:
This lesson will take us one week to complete. Please refer to the Course Syllabus for specific time frames and due dates. Specific directions for the assignment below can be found within this lesson.
Activity | Location | Submitting Your Work |
---|---|---|
Read | The Prize: Chapters __ (select sections) The Quest: Chapter __ (select sections) |
No Submission |
Discuss | Participate in the Yellowdig discussion | Canvas |
Complete | Complete the Course Reflection activity | Canvas |
Each week an announcement is sent out in which you will have the opportunity to contribute questions about the topics you are learning about in this course. You are encouraged to engage in these discussions. The more we talk about these ideas and share our thoughts, the more we can learn from each other.
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.
This lesson goes into some complex oil investment concepts, expands on the way that oil became more of a commodity. Some might find this to be a review, but all need to have an understanding of how they apply to the oil industry.
Historically, the United States has led the oil industry, thus the price of oil has been tied to the US dollar. As the price of the dollar went down, the price of oil went up; enter inflation. This would be caused by the value of the dollar going down, but the value of oil remains consistent, so the price of oil would have to go up to accommodate this currency value change. Oil has a lasting long-term value and can be used for stability for investment and ultimately gaining profit. Thus, investors can assume oil will maintain relative value over the long term. This makes it a good commodity to hedge higher risk investments. The demand for oil will continue to grow, as oil does not have a strong or consistent competitor through alternative energy options. The power of the oil industry will continue until an economically viable alternative gains a significant market share.
The Quest goes into extended focus on the 1970s - 1980s oil trading, beyond the daily trading. Going into the 1970s, oil companies were integrated, following the example of Rockefeller as he built Standard Oil. Taking all the parts of the process under one large company allows for the company to absorb higher costs with higher profits along the process. The nationalization of oil companies in many oil-exporting countries contributed to the breakup and new approach to the flow of oil. The oil-exporting countries did not want the challenge of finding the individual consumer, but instead to pass on the risk to international oil companies, who were already equipped with gas stations all over the world.
The separation of the process allowed for companies to sell off the higher-risk areas and potentially make more profit while allowing for new speculators to enter the Wonderful World of Oil.
How do oil prices relate to the US dollar?
What are some characteristics of oil trading?
With oil now a commodity in the 1980s and prices spiraling downward compared to the surge in the 1970s, the question was, “How low can it go?” The answer to that had huge implications on the oil companies, the future of “oil power,” global economy, and the shifting balance in world economic and political strength. Clearly, high prices favored exporting nations (OPEC and non-OPEC), and low prices favored the oil-importing nations (Germany, Japan, and the many developing nations). The U.S. had interests on both sides, as it was the world’s second-largest producer and the world’s largest importer and consumer. OPEC was not helping its own situation with failing quotas and member cheating.
The third oil shock was as dramatic as the crisis of 1973-74 (first oil shock) and 1979-81 (second oil shock) except that the consequences this time were in the opposite direction as noted in the figure below. West Texas: crude that had sold at $31.75 per barrel in November 1985 had fallen to $10 per barrel (70% drop in a few months). Not only were prices falling, but they were out of control, and, for the first time, there was no price-setting system or structure - no official OPEC price.
Of course, consumers were ecstatic as their standard of living and improved lifestyles were no longer in jeopardy. If the prices continued to stay low, there was fear that consumption/demand would rise, domestic production would decline, and imports would again flood the U.S. market.
The issue with price cut goes back to the question of: how low can it go? or where would the price fall stop? Cuts in production would make non-OPEC oil, alternative energy sources, and conservation flourish in addition to the huge revenue loss.
Ironically, whereas in the past it was high prices and limited supply that was considered a national security risk, now the risk was too low prices and overabundant supply. Eventually, it was determined by all concerned parties that $18 per barrel, $11 less than the official OPEC price of $29, was the “right” price of oil. This was the equivalent of the mid-1970s price after correcting for inflation. This was felt to be the price that would achieve all the competing objectives: make oil competitive with other sources and conservation, stimulate worldwide economic growth and demand for energy, and cap or reverse the non-OPEC production. With the consensus within OPEC, the U.S., and other non-OPEC countries for $18 per barrel, and the good faith effort of all parties, the market stabilized, and the “good sweating” eased.
Lessons learned during the Oil Shocks included the importance of stability of demand & supply and the fact that price stability and ample supplies were necessary to ensure this. As we exit the 1980s, conflict is brewing again in the Middle East.
1989 was the miracle year in which the East-West confrontation, or the Cold War, was over. The communist Eastern Europe regimes and the Berlin Wall had all collapsed, and the Soviet Union was in a historic transformation from political and economic changes as well as ethnic nationalisms. German reunification was solidly on course, with Germany poised to be the dominant power in Europe. Japan was viewed as the global financial powerhouse, and future confrontations were expected to be based on money, markets, and economic growth.
Oil, except for its environmental concerns, had become unimportant and just another commodity. There were no concerns in the U.S. about supplies, as proven reserves had increased from 670 billion barrels in 1984 to 1.0 trillion barrels in 1990. It should be noted, however, that the world reserves were still concentrated in five major oil producing countries in the Persian Gulf plus Venezuela. Demand was growing, American production was declining, U.S. imports of oil were climbing, and at its highest point, conservation was slowing, efforts to develop alternatives had become anemic, the security margin (the difference between demand and production) was shrinking, low prices and low security of supplies were the order of the day, and the world was moving to heavy dependence on Middle East oil again! Even with the conflict and tension between energy and the environment unresolved, energy issues seemed like a footnote and a thing of the past.
In July 1990, Saddam Hussein, under the pretext of serving as the enforcer of OPEC’s new quota system and threatening Kuwait and the United Arab Emirates if they cheated, amassed 100,000 troops on the border with Kuwait. Interestingly, the only OPEC country that was cheating by mid July 1990 was Iraq! He promised Egypt and Jordan that he had no plans or intention of hostile action but was only there to serve as a deterrent for cheating. On August 2, 1990, however, Iraq invaded and annexed Kuwait, claiming that Kuwait belonged to Iraq and that the Western imperialists (the British) were the ones who had arbitrarily partitioned the two countries to deny Iraq of its oil.
After the invasion, there was Iraqi plundering of Kuwait. On the basis of oil, but not cheap oil, as a critical element in global balance of power and stability, the world, led by the U.S., had to act, and the U.S. helped to put up an unprecedented international coalition to face up to Iraq. With the embargo, 4 million barrels of oil were lost from world supplies, similar to 1973 and 1979, and, as expected, uncertainty, fear, and anxiety caused a sharp rise in prices and the fall of financial markets.
Shortly after the start of the Gulf War, the invasion of Kuwait by Iraq, oil went from $30 to $40 a barrel, but within hours it had plunged to $20 a barrel, well below what it was even before the war. The Strategic Petroleum Reserve (SPR) was used, and besides, demand for oil was falling with the passing of winter. With the extreme success of the initial attacks and the use of the SPR, fear was removed, and supply and demand pushed the price down.
Iraq’s withdrawal from Kuwait led to an oil-related environmental disaster, and it was intentional. Iraq withdrew from Kuwait with vengeance and vindictiveness by initiating the largest oil spill in history (still is), setting Kuwait and its oilfields on fire, and destroying them if it could not have them. More than 600 oil wells were set ablaze creating a huge environmental damage/catastrophe.
The war showed the effectiveness of the energy security system built around the International Energy Agency (IEA) and the Strategic Petroleum Reserve (SPR). IEA provides a framework for the coordinated response and exchange of timely and accurate information among nations. SPR also demonstrated that given time, markets will self-correct, adjust, and allocate. All six major oil price disruptions from 1950 -1991 had shown that logistics and supply systems can adapt to minimize the impact of shortages. For example, in the 1970s, the issue was not one of real shortage but the disruption of the supply system and the confusion of who owned the oil. Also, in the 1970s, the U.S. political system was paralyzed and in disarray, with no rational and coherent policy. And, of course, Watergate was a major part of the problem.
The industrial world faced a resurgent wave of the environmental movement. The first wave that came in the 1960s and early 1970s focused on clean air and water and accelerated the switch from coal to fuel oil for heating and power generation. The second was concentrated on slowing or stopping further development of nuclear power. The third wave that started in the 1980s was in reaction to climate change/global warming and its devastating effect on forests, weather changes, and natural disasters. Among the most significant energy related environmental disasters or events since the 1980s are the Chernobyl nuclear accident in 1986, the Exxon Valdez oil spill accident in 1989, and the 2010 BP Deepwater Horizon oil spill in the Gulf of Mexico. It is clear that the drive for energy security will coexist with the third and future waves of environmentalism as we develop sustainable energy policies.
The Epilogue allows for some closing thoughts on the story told within The Prize. For most of the 1990s, oil was not as important as a strategic issue or commodity, as it was abundantly available and at a low price. Most of the attention was shifted to the emergence of China as a powerhouse in the global economy. In 1997-1998, however, Asia’s economic miracle/bubble burst (starting in Thailand), resulting in a financial panic, bankruptcies, defaults, and a deep economic downturn in most of Asia as well as other emerging markets that included Russia and Brazil. With oil supplies increasing and demand falling from the drop in Gross Domestic Product (GDP), inventories overflowed, and prices dropped to $10 a barrel, just as in 1986. Russia, just as in Mexico earlier, went virtually into default and bankruptcy. For the oil-importing countries, the fall in oil prices was like a big "tax cut" again or a package that stimulated economic growth. It helped to put the lid on inflation, pushed gas prices down at the gasoline pump, and sparked America’s passion for fuel-efficient SUVs and light trucks.
With issues on oil (security and price) taking the back seat in the 1990s, the exciting “new” thing was the Internet that revolutionized the world economy and communication. The Internet made distance suddenly disappear and the world interconnected 24/7. Suddenly, the new generation was not interested in jobs in the “old” oil industry.
Three events in the decade 2000-2010 changed the oil view after the 1990s. The first was on September 11, 2001. Major changes that have occurred in the Middle East since September 11, 2001, including the renunciation of nuclear weapons by Libya in December 2003, the emergence of Abu Dhabi, Qatar, and Dubai as global energy players and economic centers, and the protests that started in Tunisia and propagated to other states like Egypt, Lebanon, Syria, Bahrain, Yemen and Saudi Arabia for freedom and democracy in 2011. The Iraqi oil industry is still struggling to regain production due to a lack of technology, skills, security, and a strong political structure and government.
The second major event of the decade is globalization. The world economy tripled in size between 1990 and 2009, and by 2009, a major fraction of the world’s GDP was generated by developing countries as opposed to the countries of North America, Europe, and Japan. The years 2003-2007 saw the best global economic growth in a generation, and the growth implied strong demand for oil, especially in China and India to power industry, generate electricity, and fuel the many cars, trucks, and planes.
The third major feature is the surge in oil demand that caught the oil industry itself by surprise and resulted in the industry playing catch up as a result of low investments in new oil and gas supplies in the previous decade. During that decade, Wall Street actually demanded the oil industry to be disciplined, cautious, and even restrictive in its investment to avoid low stock prices. Geopolitics also contributed to restricting supply, as illustrated below using Russia as an example.
Hence the Third Oil Shock was upon us. The concern over confrontation with Iran and the fear of its impact on oil flow through the Strait of Hormuz, the “Iranian Premium,” caused an increase in oil prices. Also, the shortages of skilled labor, equipment, and engineering skills, coupled with the high cost of steel for offshore platforms and other equipment, led to high costs in developing new fields, that doubled between 2004 and 2008. This, together with the heavy investment of investors in oil as assets alternative to stocks, bonds, and real estate that could yield high returns, further drove the price of oil higher. The weakness of the dollar relative to the euro and yen further increased the price of oil, as investors hedged against the dollar’s decline. People expected demand for oil in China and India to go off the chart, resulting in oil shortage and higher prices. All the above factors, supply and demand, geopolitics, costs, financial markets, expectations, and speculations combined to push prices from $30/bbl around March 2003 to over $145/bbl in 2008. “By that point, expectations had created a bubble in which the price was increasingly divorced from the fundamentals. For as prices went up demand had inevitably begun to weaken.”
While the oil shock in 1973 was triggered by the Yom Kippur War and the one in 1978-79 by the Iranian Islamic revolution, there was no single specific event that triggered this new oil shock. The wild price fluctuations noted in the figure below align with seminal events triggering the jumps. In the US, the situation was worsened by the credit crises that hit the mortgage and financial sectors. Only when demand growth slowed markedly, in response to high prices, and the financial crises (the worst since the Great Depression) and a worldwide recession occurred did the price of oil come down dramatically. The rise in oil prices certainly led to the transfer of huge sums of money from consumers to exporters, and the drop led to less transfer of income from importers to exporters such as Venezuela, Russia, the United Arab Emirates, Qatar, China, India, and the USA.
Clearly, a growing world economy, coupled with rising income and population growth can only mean the need for more oil. Thus, for decades or even centuries to come, oil will continue to be a factor in national policies and strategies relating to politics and the global economy. It will continue to play a role in how people live. Coal politics, oil security and cost, fuel efficiency standards, alternatives, nuclear waste, and security of infrastructure (e.g., pipelines) will all continue to be questions and choices we will face moving forward.