Why Were We So Surprised? (by oil price fall)

The Oil Glut, Saudi Decisions, and the Uniqueness of U.S. Fracking Jeremy Grantham

Summary

■ The simplest argument for the oil price decline is for once correct. A wave of new U.S. fracking oil could be seen to be overtaking the modestly growing global oil demand.

■ It became clear that OPEC, mainly Saudi Arabia, must cut back production if the price were to stay around $100 a barrel, which many, including me, believe is necessary to justify continued heavy spending to find traditional oil.

■ The Saudis declined to pull back their production and the oil market entered into glut mode, in which storage is full and production continues above demand.

■ Under glut conditions, oil (and natural gas) is uniquely sensitive to declines toward marginal cost (ignoring sunk costs), which can approach a few dollars a barrel – the cost of just pumping the oil.

■ Oil demand is notoriously insensitive to price in the short term but cumulatively and substantially sensitive as a few years pass.

■ The Saudis are obviously expecting that these low prices will turn off U.S. fracking, and I’m sure they are right. Almost no new drilling programs will be initiated at current prices except by the financially desperate and the irrationally impatient, and in three years over 80% of all production from current wells will be gone!

■ Thus, in a few months (six to nine?) I believe oil supply is likely to drop to a new equilibrium, probably in the $30 to $50 per barrel range.

■ For the following few years, U.S. fracking costs will determine the global oil balance. At each level, as prices rise more, fracking production will gear up. U.S. fracking is unique in oil industry history in the speed with which it can turn on and off.

■ In five to eight years, depending on global GDP growth and how quickly prices recover, U.S. fracking production will start to peak out and the full cost of an incremental barrel of traditional oil will become, once again, the main input into price. This is believed to be about $80 today and rising. In five to eight years it is likely to be $100 to $150 in my opinion.

■ U.S. fracking reserves that are available up to $120 a barrel are probably only equal to about one year of current global demand. This is absolutely not another Saudi Arabia.

■ Saudi Arabia has probably made the wrong decision for two reasons: First, unintended consequences: a price decline of this magnitude has generated a real increase in global risk. For example, an oil producing country under extreme financial pressure may make some rash move. Oil company bankruptcy might also destabilize the financial world. Perversely, the Saudis particularly value stability. Second, the Saudis could probably have absorbed all U.S. fracking increases in output (from today’s four million barrels a day to seven or eight) and never have been worse off than producing half of their current production for twice the current price ... not a bad deal.

■ Only if U.S. fracking reserves are cheaper to produce and much larger than generally thought would the Saudis be right. It is a possibility, but I believe it is not probable.

■ The arguments that this is a demand-driven bust do not seem to tally with the data, although longer term the lack of cheap oil will be a real threat if we have not pushed ahead with renewables.

■ Most likely though, beyond 10 years electric cars and alternative energy will begin to eat into potential oil demand, threatening longer-term oil prices.

What Is Going On?

It is an unusual and dramatic event when oil halves in price in a few months. Indeed, except for the crash of 2008 it has never happened before since 1900. (It dropped by two-thirds from the end of WWI until the depths of the Depression in 1932 and it dropped 75% after the 1980 peak caused by the Iran-Iraq war and other factors, but in both cases it took several years.) This time, there we were, muddling through quietly, minding our own business, when, Bang!, it happened. Or that is how it felt to most people and most economic commentators. So what was going on? And how unexpected should it have been? Demand- or Supply-driven Bust? Oil is recognized as being central to our economy, yet, if anything, its historical role has been underestimated. I argued last quarter that without it our modern economy would not exist and its replacement would be unrecognizably less advanced. Given the complexity of the oil and energy industries, it is probably not surprising that the analyses available for this unique decline differ so widely. The reasons given range from the ingenious to the brutally simple.

I usually have a soft spot for ingenious arguments, but for once I believe the simplest case is the right one this time: that it was not unexpectedly weak demand but relentlessly increasing U.S. oil supply that broke the market. There is little that is dramatic about recent GDP growth or oil efficiency. Global GDP growth has been a little disappointing continuously for several years and I believe is likely to continue to be so until official expectations become more realistic. (The official estimates two years ago for trend line U.S. GDP growth were as high as 3%, an extrapolation of earlier growth despite a recent and probably permanent 1% reduction in labor growth. Estimates are now close to 2%, but until they reach 1.5% they are likely to continue to cause mild but steady disappointment in delivered growth in the U.S. and the developed world.) But this disappointment has been slow and steady from the 2009 economic low and many oil experts, I am sure, learned to adjust for it.

Increases in the efficiency of oil usage have also been steady but unsurprising. The end result for oil usage in any case was a very boring series of small increases. 9 GMO Quarterly Letter: 4Q 2014 Exhibit 1 shows the change in oil production from the U.S. and OPEC. In great contrast to the picture for oil usage and efficiency, we now see some drama. Such large increases from one source – U.S. fracking, which accounted for over 100% of the U.S. increase, went from about 0% to 4% of global production in only five years – have not been seen since the early glory days in Texas, Pennsylvania, and Baku in the 19th century and in the Middle East in the 1950s and 1960s. Exhibit 1 also shows that in 2013 and 2014 increases in U.S. fracking production equaled 100% of the increase in global oil demand. Worse yet for OPEC, the estimate by June 2014, with the price still around $100, was for U.S. fracking production in 2015 to be even higher than the estimated total increase in global demand this year! More importantly, the increasing surge from U.S. fracking had absolutely not been expected as recently as 2009.

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