Oil Prices

¶ … Oil replays 1980s bust discusses the collapse in oil prices in the mid-80s versus the collapse in oil prices in the second half of 2014. He notes that while the pace of decline was similar, than the reasons behind the decline are different. The author notes that time is an important variable. Prior to hydraulic fracking, oil projects were massive in scope and scale, and took many years and billions to bring to fruition.

As a consequence of this, the supply of oil on world markets was fairly easy to predict. New oil would not suddenly materialize from just anywhere. Today, the time lapse between when oil is discovered and when it hits the market is much shorter, and the cost is lower. The wells in the shale fields are smaller, so the entire exploration and extraction cycle (i.e. The cash conversion cycle) is shortened considerably. This also encourages new money to get into oil, because the returns come faster.

In the 1980s, there was a lot of new supply coming onto the markets, but the oil supply was still in the market as well. This created a glut, which combined with a sustained reduction in demand, drove prices lower. Ultimately, oil prices are determined by supply and demand conditions. The author looks at the supply and demand conditions for the current global oil market.

The supply has increased significantly with the new shale developments, at a point when demand in the West is peaking -- there is still some growth in places like China but the increase in supply has outpaced the increase in demand. Industries observers rightly point out that oil is still finding its equilibrium point. Because of the short cash conversion cycle, the market will adjust more quickly to the latest price declines, as the low prices will stunt the development of new wells.

This will slowly re-align supply with demand, causing prices to rise back up. The only real issue is how long this process will take, and where the equilibrium point will be (Gold, 2015). The role of OPEC in the price movements should also be considered. OPEC is a cartel, and their management of global oil production is one of the mechanisms that reduces the influence of the market, in order to influence the prices.

OPEC would normally seek to maintain higher prices by cutting its output (and thus global supply), something that happened to some extent in the 1980s. At that time, it took almost two decades for prices to return to their pre-crash levels. However, today OPEC has determined that it will not lower its output to increase the price of oil. The reason is that OPEC nations are typically the lowest-cost producers, and therefore they can be profitable at low prices, where many competitor cannot.

The competitors therefore will be flushed out of the market by the low prices -- OPEC's move is to basically leverage its low cost of production to restore its market share, which to this point has declined because much of the new production is in non-OPEC countries, the U.S. And Canada in particular. Gold (2015) notes, however, that technological improvements and economies of scale are lowering the cost of shale production. That means that the decline in output in the U.S.

And Canada is not going to fall as quickly as OPEC might have hoped. As a consequence, global oil output, and thus prices, might remain at current levels for longer than OPEC planned. This is the uncertainty in the oil market. Demand is not likely to increase too much over this period, as shifting consumer tastes are moving towards reducing consumption of fossil fuels where possible, a trend that is expected to.