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The Oil Market May Well Not Turn Out This Way

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We all, of course, love Ambrose Evans Pritchard dearly. We all also, obviously, know that he can be a little overenthusiastic at times – sort of the excitable sheepdog of economic journalism.

At which point much about this exploration of the oil market is reasonable, possibly even correct. Except, I think, for the one point:

The greatest threat to Saudi Arabia and Russia over the next five years is a roaring bull market for crude oil, worse yet if prices spike to all-time highs of $150.

Such an outcome is probably baked into the pie already. There is not enough supply coming on stream to replace the structural decline in old oil wells. The crunch will come before electric vehicles eat seriously into global fuel demand.

Everyone’s stopped bringing Big Oil online but demand is going to fall more slowly that expected, thus we’ve one more, at least, price peak to go.

Mr Hess expects a V-shaped recovery in demand, inadequately matched by “sticky” U-shaped recovery in output. This time America’s shale frackers will not come to the rescue. In the glory days, they responded quickly and with gusto every time prices picked up. They made up the entire increase in global output over the last eight years.

“Shale’s gone from a growth business to a harvest business. Too much money was thrown at shale from 2015 to 2017,” he told IHS Markit’s CeraWeek.

“Discipline broke down. Frackers went all out for expansion, gobbling up $80bn of equity investment, and much debt, to cover capex spending running at 130pc of cash flow. They lost three times that amount of money this year. There have been 80 bankruptcies.

Shale is the swing producer, that is indeed a problem. But, it’s only a problem if that is what happens. Which is where I disagree.

The basic model is this: resource extraction is known to move in waves. Simply because each and every project is a vast one. You’ve got to be able to see the possibility of large profits to be able to pull together the many billions you need in order to be able to do the project. This means that resource prices have a tendency to boom and bust. In the jargon, we’ve got supply being relatively inelastic to price. We can’t just turn on another North Sea when demand for oil goes up. It takes us a decade or more to even exploit one field, let alone an entirely new basin. Further, we know that short and medium term demand is also relatively inelastic with respect to price. So, in recent decades we’ve had oil at $80 a barrel, $14, $140, $50: we’ve had huge price swings. And those price swings have been large enough to affect the macroeconomy of the entire world. We can blame the 70s and 80s on the fight between a decaying Keynesianism and the rise of Reagan and Thatcher if we want but a lot of people would point to the 73 and 79 oil price shocks.

And in this model fracking for tight oil over turns this basic reality of resource extraction. Price is, of course, driven by the marginal supply and or demand. And fracking doesn’t require vast investments, nor does it take a long time to get going. Say that North American tight oil is only profitable at $50 or $60 a barrel. So, oil heads up to $80 say. At which point people can start spudding wells again: and they will. That oil comes online in a few months at most, they make their money in the first 18 months and they’re happy. But that marginal production means that we’re simply not going to see the vast variation in oil price of the past. What fracking has done is given us a marginal producer not subject to long lead times or high capital requirements. And thus the elasticity of supply with respect to price is much greater than it has historically been. Meaning that the price variations dependent upon that low elasticity are going to be dampened.

That’s a very big macroeconomic change for us all, that the oil price is likely to be stable under $80 or $90 for the foreseeable future. And all because of that technological change: the technological change which most economic models relegate to a residual in the microeconomic models. But here, large enough that we can pretty much rule out certain macroeconomic situations. I certainly wouldn’t believe the result of a model that predicted $150 or $200 oil in any period of more than a few months over the next few decades for example. That’s a big change: especially when we really did have $150 oil only a couple of years back.

It may even be true that the current fracking companies aren’t going to return to the fray. But when it only costs about $5 million to get another well going there’s never going to be a shortage of people willing to give it a go if prices spike. It’s also true that the bulk of the revenue from a fracked well comes in the first 18 months.

We’re in a world with much more – at the margin at least – elasticity of supply. Therefore we’re most unlikely to have the price peaks of the past.

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