As the first quarter of 2015 draws to a close, we are beginning to get used to the concept of cheap oil. The question on everyone’s minds, of course, is how long it will last. March has seen the lowest oil prices since the SemGroup implosion of 2008, dipping to $45/barrel. While 2015 has seen highs as great as $55 for WTI, prices for the majority of year have been below $50. And every day, there is a new voice added to the oil price forecast. On March 30, Barclays called for $39 WTI in the second quarter. Still, the first quarter’s $10 (20%) swing indicates a huge amount of volatility and reflects the dissonance the global energy markets are experiencing. This problem goes well beyond a commodity price issue. Really, the collapse in the price of oil calls into question the stability of global markets generally, and challenges the interplay between commodity prices and greater global stability.
Nuclear talks in Iran, potentially resulting in the lifting of oil embargos, would allow another million barrels of oil per day onto the market, putting further substantial downward pressure on oil. The downward pressure may or may not be reversed by other hot spots in the Middle East, such as Saudi Arabia and Yemen, or by the continued activities of ISIS in Iraq and Syria. Certainly, there is limited stability in the OPEC nations.
While, yes, it is important that Iran start participating meaningfully in the world economy, that is another million barrels over and above the current bumper crop. In 2014 the United States had the largest oil production increase in 100 years, according to the EIA. However, at half price oil, all that increased production was better served staying in the ground. With no coordinated planning of supply, the individual pursuit of the marginal barrel just means every barrel is worth less. OPEC is not playing nice, and oil producing nations are not doing themselves favors by having their most productive years in history.
Figure 1 – US Total Crude Production 2010-2014
Looking at the forward price view from August 2014, before the most recent price collapse, we see prices north of $90 for WTI (red line in Figure 2) and north of $100 for Brent (dark blue line in Figure 3). However, just six months later, in February 2015, we see the forward curves down by more than 40% for both benchmarks (orange line in Figure 2 and light blue line in Figure 3).
Figure 2 – August 2014 vs. February 2015 forward price view for WTI
Figure 3 – August 2014 vs. February 2015 forward price view for Brent
What is unusual is that the curves from August 2014 and February 2015 do not converge. This means that the change in outlook is not merely that of a temporal market anomaly, like a war, but a sustained fundamental change in the way the global market considers energy as a commodity. If that is the case, why did it take a total market collapse for people to internalize the true impacts of the shale gas revolution, the supply dynamics of OPEC, or the global economic effects of recession?
And to be clear, this is not just about oil; one can see a similar disconnect in natural gas and power markets, though maybe not as dramatic. Natural gas was misjudged by more than $1 (Figure 4) and power by $5 (Figure 5), which are still massive risk exposures if you are on the wrong side of the price curve.
Figure 4 – August 2014 vs. February 2015 forward price view for natural gas
Figure 5 – August 2014 vs. February 2015 forward price view for MISO
One still has to ask, in this age of unlimited data, when there is universal real-time sharing of global events and multi-million dollar energy and commodity trade and risk systems, how can the market be off by so much? How can millions of traders around the globe all miss the market collectively? Is there really no shared wisdom?
Are Ideologies Really to Blame?
If you were inclined to simple answers, you would say that this breakdown is the fault of Western style capitalism – the pursuit of economic freedoms and the wealth of nations at any cost (or more accurately, anybody else’s cost). Long live the memory of Adam Smith and his bourgeoisie (impelling the burgeoning corporate world). However, if you lived in the East (including East Berlin), you may say that the fault belongs to communism and an errant manifesto – the utopian ideal of releasing the masses from the class struggle fails to recognize economic realities of running a nation. Long live the memories of Karl Marx and Friedrich Engels. Thus, we observe in 1776, and later in 1947, the philosophical underpinning for war, both hot and cold, as each nation pursues Pax in the manner most befitting its philosophical bent.
In the West, we see technological innovators that drive personal wealth, massive infrastructure, and ideological change eventually forcing government reaction. In the United States, these forces included the founding father, Benjamin Franklin, who became a wealthy publisher and was perhaps the most influential person in shaping the modern Western state and the ideals of freedom from imperial oppression. Thereafter, we have the energy pioneers such as Rockefeller and Edison whose technologically revolutionary achievements transformed the nation and produced unbelievable wealth. This wealth stretched railroads westward, put cars on highways, sent oil east on tankers, fueled airplanes and tanks, and spurred the growth of the most powerful nation in the world. The indefinite pursuit of $100/barrel oil while in no way restraining supply was, in hindsight, pure folly. It is as if the economic concept of supply and demand does not exist.
But when the power of the wealthy infringes on the masses, when corruption becomes the norm and not the exception, when markets fail, and when the people go hungry, the regulator finally steps in. The regulator is thus the one to free the people from corporate oppression. In the words of historian James Truslow Adam on the American dream: “Life should be better and richer and fuller for everyone, with opportunity for each according to ability or achievement regardless of social class or circumstances of birth.” Sounds a lot like Marx and Engels: “In place of the old bourgeois society, with its classes and class antagonisms, we shall have an association in which the free development of each is the condition for the free development of all.”
And, as is the wont of the regulator, the reaction is often overbearing and under-thought. Rockefeller was forced to heed the regulator. He had captured the ire of the first Roosevelt, who chased Rockefeller across the country in his efforts to subpoena him and apply the Sherman Antitrust Act of 1890, which was enacted to regulate competition in the new US market economy. Teddy was committed to breaking up the trusts and dismantling the world’s first monopoly, the Standard Oil Company. Ironically, though, Rockefeller quintupled his wealth as his monopolistic Standard Oil was broken up.
Energizing a Nation
It was not until after Edison’s death that the holding companies that had taken over and corrupted the electricity industry were confronted by the second President Roosevelt, Franklin D. Roosevelt. I think his mind must have been divided between the views of Samuel Adams and James Adam. On one hand, he needed to confront the corruption of the holding companies, and on the other, bring the country out of recession. He enacted the Public Utility Holding Company Act (PUCHA, 1935) to break up electric holding companies into state utilities, much the same way that Teddy had broken up Standard Oil. Today, there still exist many Edison companies: Commonwealth, Consolidated, and so forth. Probably the most famous involves the merger of Edison General Electric with Thomson-Houston Electric Company to form General Electric (GE). Franklin D. Roosevelt also electrified the nation and invigorated the US economy. His New Deal included a vision of massive infrastructure development. He built the highways and the dams that connected a nation and powered the future. The establishing of the Bonneville and Tennessee Valley Power Authorities contributed to the federalization and ruralification of energy through cheap and abundant hydro power.
But before he addressed the energy sector, Franklin D. Roosevelt stabilized banking by putting in place the Federal Deposit Insurance Corporation (FDIC), suspended the gold standard to support monetary reforms, passed the Gold Reserve Act to contain the economy, put in place the Securities and Exchange Commission (SEC) to regulate the stock market and prevent corporate abuses, and a host of other activities to bolster the proletariat and free the capital machine. By the time the United States was to enter World War II, the country was fully energized: flush with money, replete with oil, fully electrified, and gainfully employed.
The United States reached full employment after entering World War II in December 1941. The Gross Domestic Product doubled immediately in the all-out effort to supply the war machine. The United States was the most domestically isolated, best equipped, and best supplied force in the world. Coming out of the War, the United States was the clear winner and the preeminent super power. Post war, the GI Bill (Servicemen’s Readjustment Act of 1944) ensured that 16 million returning veterans were housed and ready to serve in their new role of expanding the American middle class.
Indeed, The US post-war era featured an economic boom, the long boom, and a sustained period of relative peace. Within a day of the end of WWII, the gas rationing that had existed to support the war effort was over, though little thought or concern was given as to where that supply would come from. And it is at this euphoric point in US history that a new age begins, leading to unprecedented prosperity for the United States, and ironically for Germany and Japan under the Marshall Plan. Britain and Russia would not fare as well. The greatest lesson arising from the war was that energy makes nations. Oil wins wars. And oil was too valuable for the management of it to be left to business men. The American Pax was now fully in play – energy security at any cost.
The Unpredictable Consequences of Innovation
In this heyday of capitalism, prosperity and innovation reigned, as did cheap and abundant energy to fuel the boom. In fact, post war, there was an oil bonanza. The issue was not supply but how to ensure that oil would not become worthless. But coordinating supply and demand from the top is a tricky business – one that has never been mastered. There are just too many pieces, too many conflicting interesting, and too much money at stake. Oil had become the lynchpin to global economic development and security. The American Pax had secured cheap, reliable energy from the Middle East, and the legacy of the New Deal ensured a fully electrified and interconnected nation. This prosperity would last until the collapse of the Bretton Woods system in 1971 and the 1973 Oil Crisis. Again, gold and black gold colluded to turn the markets on their heads.
The Oil Crisis of 1973 put the United States fully on its head with respect to oil policy. The United States began to spin, much like it spun in the first and second oil crises a century earlier and in every major crisis thereafter. The spin may have come from a lack of confidence and the fervor of Pax as the United States tried once again to ensure its energy and security. This security became tied to the pursuit of freedom. Energy equated to strength: economic strength, political strength, and strength in the war. In the absence of abundant and easy to access cheap energy, there was a perceived vulnerability. The United States believed this, as did the Russians.
Both countries were already deep in a cold war and an armament race. The nuclear age was in full swing, and both countries were determined to beat the other in the number of times they could theoretically blow up the world. The question at the time was: who had enough money to beat the other in the contest of mutually assured destruction?
In the United States, the military industrial complex was fully released. It had emerged during WWII, and it was in overdrive in the 1980s and ’90s. The Cold War effort indirectly led to commercial unbridling, the Internet, and the rise of both the technology play and the commoditization of everything for everyone. The baby boomers could trade stocks on America Online, buy their books on Amazon, then turn to Event Horizons BBS (bulletin board service) to watch their adult-only content on their PC Clone or Apple Macintosh Classic. In 1993, Event Horizons made $3.2 million gross. Amazon, on the other hand, did not turn a profit until 2001. This just goes to show that the downstream effects of technological innovation, market occurrences, and political exchanges are almost impossible to predict. Just like how video killed the radio star, the Internet killed the bookstore. In like fashion, errant policies and regulation can kill a market or destroy a foreign nation or group of nations.
The Certainty of Uncertainty
While Obama may not be a warmongering president, his term is nearly up. The next president may be of a different sentiment, especially with ISIS on the rise. However, it is clear to see that the last ill-thought war on terror only had the effect of taking terror out of the newsroom basement and making it primetime 24/7. In the efforts to stabilize in the name of freedom, personal freedoms were sacrificed, as well as countries, and a new form of global uncertainty was unleashed. The socio-economic mess the globe is in today is certainly the result of single-variable thinking in conflict resolution. The question is, what is driving us today? Is it a corporate/business objective or a government policy objective?
While the US industrial military machine may be still sated from Iraq, if another nation leads the trade war with Asia, long run economics may come into play. The big alliance plays are happening now. Whether Brazil stands a chance in this game is doubtful. The same goes for any of the other lesser 80 or so oil suppliers. But Russia does have a serious opportunity. And they have shown they can make their mark on this market, as testified by their recent natural gas play with China. Given the current price of oil, maybe the gas was not discounted after all.
In the end, we still have more questions than answers. There is no consensus on oil or natural gas prices today; the implied consensus at market closing is fictitious and temporal. There is no consensus or potential resolution to Middle East conflict. There is no clear way through the impasse over Crimea. There is no reasonable expectation that the Eurozone is going to climb out of its economic mess into the foreseeable future. So, all that being true, we all have to ask ourselves, what does $50/barrel oil really mean, and can we use this as a mechanism to move ourselves forward? Or, if the basis for energy pricing is being rewritten, what else should be rewritten at the same time?