As of last March 30, oil had traded as a commodity on open exchanges for 40 years. Most people do not remember a time when “WTI” oil was not quoted as “the oil price” by news sources in the United States or “Brent” internationally. It was not always so.
From the early 1930s to the 1970s, the international oil industry was dominated by seven large, publicly traded, integrated oil companies: five American plus British Petroleum and Royal Dutch Shell. The American domestic industry had about 35 such “major” companies including the five which operated internationally. “Integrated” companies were companies which looked for new fields, drilled them, produced them, transported the oil, refined it, and sold the products in their own gas stations and other outlets. They partnered with each other on some projects but mostly maintained their own supply chains to their retail, commercial, and industrial customers at fixed prices. They maintained production capacity about 12% to 15% in excess of demand to assure they could supply their customers in the event of disruptions to any part of the supply system.
With this system, supplies were reliable and prices stable - through the Great Depression, World War II, the Korean War, post-war economic expansion, and the Vietnam War - until they weren’t.
The US Government, for some reason understood only by itself, encouraged OPEC to take control of international oil markets and prices in 1971. Nixon then cut the link between the dollar and gold. Oil trading and prices were all on a frantic spot market for several years in a tumultuous period of financial, economic, and political upheaval worldwide.
Trading contracts for 1,000 barrels of West Texas Intermediate oil in tanks in Cushing, Oklahoma, started on the NYMEX on March 30, 1983 followed later by trading Brent oil on the London ICE. Oil became a traded commodity.
Open exchange trading quickly revealed world oil productive capacity exceeded demand by about 30%. Prices crashed as traders bid prices down to the minimum to meet demand. It took 20 years for the market to work off the supply overcapacity at an average oil price of about $18. With excess supply capacity and oil traded on open exchanges with publicly quoted prices, the integrated major oil companies mostly disappeared. Only two American companies are left: Exxon and Chevron. The industry fragmented into production companies, transport companies, refining companies, and marketing companies. As is typical of commodities, excess capacity and supply resilience were squeezed out of the system by low prices.
In the mid-2000s three trends converged:
- World oil demand, for the first time in history, approached world oil production capacity..
- A major U.S. financial crisis spread to Europe and worldwide. In response, the Federal Reserve injected liquidity into the economy; a program known as Quantitative Easing (“QE”).
- An extended period of field tests to combine improved hydraulic fracturing and horizontal drilling technologies to recover oil and gas from very-low-permeability (“tight”) reservoirs was successful.
Suddenly we had a shortage of oil, prices started to rise, and the necessary capital and technologies were available to develop large new U.S. oil and gas supplies. An oil boom, the “Shale Revolution,” was on.
As oil prices rose, investment poured into oil development. Operators mobilized hundreds of drilling rigs, and drilled as fast as they could. Prices spiked up over $140 in 2008 and dropped below $40 later in the year, then recovered to around $80. The Federal Reserve stopped, then resumed QE and prices surged above $100. When the Fed stopped QE, prices crashed again. Drilling activity followed price fluctuations up, down, up, and down again. American operators kept improving drilling and well technologies and proved they could drill and produce at lower prices than the Saudis needed to run their country. Covid crashed prices and then they rose again.
Such volatility is characteristic of commodity markets. When demand exceeds supply, traders bid prices up to get the last barrels available to sell into a hungry market. Operators drill quickly at high costs to catch the high prices, but they always overdrill. Prices then crash as traders bid prices down to cover just enough operating costs to supply demand from the most efficient operators. Operators with high operating costs are taken over by low-cost operators. Then the cycles repeat.
Oil is a foundational component of a modern economy. Such price volatility is disruptive and the Ukraine War revealed a lack of resilience and reliability in the system. Oil market relationships are being re-structured. We can expect more and more long-term oil supply contracts to be signed between oil-producer governments and their customers with more stable price structures. Most of these will be on a government-to-government basis. Some governments have oil companies, which act as agents for them in such relationships, e.g.: Total (France), ENI (Italy), but many will have difficulty establishing reliable supply sources.
China is the elephant in the room, as always. With its Belt and Road and other initiatives, it is the largest trading partner for over 80% of the world’s population. It is using that economic clout for coercion regarding various issues in more and more countries. In the last two months, since it brokered the detente between Saudi Arabia and Iran, China signed numerous contracts and acquisition deals in oil and gas supply projects. It is using its dominant positions and relationships in the Shanghai Cooperation Organization and BRICS to facilitate this rapid expansion.
An obvious conclusion is that China is assuring itself long-term oil and gas supplies at favorable and stable prices. A more dangerous possibility is that China will contract for supply capacity far exceeding its own needs and thus make itself a broker and middleman for a large part of the world’s oil and gas supplies. It would use this additional economic power for stronger coercive capability to subjugate its customers and trading partners to its dominance.