x Abu Dhabi, UAETuesday 23 January 2018

Tracking oil's highs and lows

Is it reasonable that this so-far irreplaceable staple of modern life should cost half as much today as it did three months ago?

Annual average domestic crude oil prices (US$) from 1949 to present.
Blue is nominal, red is inflation adjusted.
Annual average domestic crude oil prices (US$) from 1949 to present. Blue is nominal, red is inflation adjusted.

If tracking oil prices this year is giving you vertigo, then join the club. So far, the price of a barrel of light, sweet crude has soared 63 per cent to a dizzying $147 in July, then plunged 53 per cent to below $70. Is it reasonable that this so-far irreplaceable staple of modern life should cost half as much today as it did three months ago? Could the price movements have been forecast? Can they even be explained?

Opinions will vary, but most people would probably answer "no", "not without the sheerest blind luck", and "only with flawless 20:20 hindsight". Yet a quick examination of the modern petroleum industry's 150-year history reveals that oil prices have nearly always been volatile. The first boom-bust cycle occurred in the 1860s, just after "Colonel" Edwin Drake, a Yankee with no commission from any known army, struck oil in north-west Pennsylvania.

The ensuing oil boom, spurred by surging demand for reliable low-cost lighting, and the subsequent bust when the output from hundreds of hastily drilled wells exceeded local demand, was as extreme as anything witnessed this year. In less than 12 months between 1863 and 1864, the real price of crude, expressed in inflation-adjusted US dollars, more than doubled to above $100 a barrel, then plunged 65 per cent to about $35 in real terms by mid-1866. Whole towns based on oil drilling sprang up, then disappeared.

The 1859 Titusville, Pennsylvania oil discovery, the first in the US, is considered the modern industry's starting point, mainly because Mr Drake was a noted oil trader credited with creating the world's first market for crude. The earliest evidence of oil drilling dates from about 350AD in China. Marco Polo reported seep-oil mining in medieval Persia. Later, Polish seep oil lit street lamps in 16th-century Europe.

The first full oilfield development took place in the last years of that century near the Azeri capital, Baku, then in Persia. Wells up to 35 metres deep were dug by hand. A Russian engineer, FN Semyov, drilled the first modern oil well in 1848 near Baku - by then within the Russian empire. In 1858, North America's first oil well was drilled in Ontario, Canada, near a modern-day community named Petrolia.

But it was the US Atlantic seaboard that in the mid-19th century was primed and ready for the benefits that oil could bring to a young, ambitious nation hurtling into the industrial age; and it was a war of wills and fortunes between John D Rockerfeller, a Cleveland greengrocer turned oil monopolist, and oilmen acting independently of his Standard Oil Company, that led oil prices on an early wild ride. Later, competition from Russian oil producers sent the emerging western-hemisphere oil market on a long, bumpy ride towards crude's all-time inflation adjusted low - about $8 a barrel - shortly after the 1927 stock market crash.

Possibly the only reason we think oil prices are more volatile now than historically is because for a few years in the 1930s until the Second World War, and again in the post-war era until the early 1970s, oil markets went through interludes of unusual calm, with prices kept low by crude supplies enthusiastically pumped by new entrants to the global oil game. On Sept 14, 1960, five new players - Saudi Arabia, Iran, Iraq, Kuwait and Venezuela - unhappy with the post-war prosperity that low, stable oil prices had brought to regions other than their own, founded the Organisation of Petroleum Exporting Countries (Opec) at an inaugural meeting in Baghdad. The group's aim was to emulate Mr Rockerfeller's market-cornering tactics by establishing an oil producers' cartel.

Whether Opec has been more successful than America's first oil tycoon in influencing crude prices to its advantage remains a matter of endless debate. What is certainly clear is that its actions have sometimes had big effects on oil prices, although not all were intended. It was another 10 years before Opec began asserting power on world markets by raising posted prices for members' crude exports. In 1972, it called for nationalisation of the group's oil resources. The following year, negotiations began for the transfer of oil assets held by western oil companies in Opec countries.

Geopolitical events moved swiftly thereafter, with an Egyptian-Syrian attack on Israel in Oct 1973, Israeli counterstrikes, and an Arab oil embargo of Israel's allies, including the US, imposed the following March. By late 1974, the price of crude had quadrupled in what came to be known as the first oil-price shock. In Nov 1974, the Organisation for Economic Co-operation and Development (OECD) founded the International Energy Agency as their energy adviser and a counterweight to Opec.

After a brief lull, oil prices continued to surge following Iran's Islamic revolution in Feb 1979, which caused the loss of more than two million barrels per day (bpd) of oil production. In the second quarter of 1979, Saudi Arabia cut its crude output, sending prices still higher. The following year, a protracted war broke out between Iran and Iraq, removing 2.7 million bpd of Iraqi crude and a further 600,000 bpd of Iranian production from world markets and contributing to a second oil-price shock in 1981.

But as quickly as they had risen, oil prices fell back, as non-Opec countries mounted concerted efforts to exploit oil reserves in places like the North Sea, Alaska and the Gulf of Mexico, and industrialised nations battled energy costs with better insulated buildings and more fuel-efficient cars. By the mid-1980s, Saudi Arabia felt the need to reverse the decline in its market share of world crude production. A price war ensued, sending oil prices even lower.

In 1986, the kingdom switched to market-based pricing from posted prices, as a result capturing market share from fellow Opec producers and non-Opec countries alike. Oil prices collapsed, along with crude output from mature non-Opec basins, and Opec's spare production capacity plunged. Shrinking spare capacity severely crimped Opec's ability to stabilise prices, contributing to subsequent oil price volatility. In 1987, the group dropped posted reference prices in favour of a system of oil production quotas for its members, based on its assessment of the market's call on Opec supply. In so doing, it abandoned any claim of control over international prices. Its public emphasis from then on was influencing prices to stabilise markets.

But if that has been Opec's aim, the results have not been impressive. Oil prices briefly spiked when Iraq invaded Kuwait in Aug 1990, only to retreat until 1998, with only a brief reversal in 1994 due to civil unrest in Nigeria, the premier African Opec producer. A financial crisis erupting in 1997 caused Asia-Pacific oil consumption to fall for the first time in 15 years, giving crude's descent another push. Opec then inexplicably increased output, raising lasting questions about its ability to enforce production quotas.

By late 1998, oil prices had collapsed to their lowest level of the past decade, barely surpassing $10 a barrel. Crude started a definitive recovery in 2002, shortly after the September 11 attacks on New York and Washington DC. At first, the impressive rebound was attributed to resurgent Asian oil demand, as China and India emerged as global manufacturing centres. Later, as nominal oil prices broached triple digits, Opec blamed the rally on market speculation, while western governments pointed to falling world production, shrinking international access to high-quality oil reserves and Saudi reluctance to pump more crude.

This spring, just as the market was about to turn, Saudi Arabia and Opec caved in to US pressure to increase oil output - a move history may judge as one of the group's worst-timed decisions. The organisation may have seen its speculation argument vindicated. Nonetheless, it is scrambling to restore its credibility as a force for market stability. On Thursday evening, as crude continued plunging, it moved up an emergency meeting by nearly a month to this Friday.

Another factor hurting Opec's reputation and contributing to market volatility is the poor quality of data on oil production by member states whose energy sectors are mostly dominated by secretive national oil companies. The organisation relies on information from "secondary sources" to estimate its own output. Despite their probable contribution to the ongoing oil price collapse through lax regulation of financial institutions and markets, western governments have much genuine cause for concern about their perennial scapegoat, Opec. Investor fears of a global recession may also be well founded, as the 1973 and 1981 oil shocks both helped tip the world economy into contraction. But the world has bounced back from previous global recessions.

With oil prices, the one sure thing is that what goes up must come down - and then bounce back up. The only remaining questions are when, and how far. @Email:tcarlisle@thenational.ae