“If something cannot go on forever, it will stop,” according to Herbert Stein, former chief economist to U.S. President Richard Nixon (“What I think: essays on economics, politics and life” 1998). Stein’s law is one of the most simple but important statements in economic theory, yet it is remarkable how often it is forgotten. Stein’s law explains why oil prices crashed from the middle of 2014 after spending more than three years over $100 per barrel
Most commentators now accept a price of $100 was unsustainable (though at the time there were plenty who predicted prices would remain at that level forever). High prices were encouraging too much new production, especially from U.S. shale, while causing consumption to fall in the advanced economies and slow in emerging markets.
The emerging supply-demand imbalance could only be resolved by a sharp price fall which was triggered in July 2014 after Islamic State fighters failed to seize Kurdistan’s oilfields and Libya resumed oil exports. In retrospect, all this is obvious, but the clues were there at the time for anyone who tracked data on stagnant consumption and accelerating U.S. oil production.
Stein’s law cannot predict when an unsustainable trend will reverse, only that it must do so eventually, and that the worse the disequilibrium becomes the bigger the correction is likely to be. If Stein’s law was relevant when oil prices were unsustainably high in 2012-2014 it is also relevant in 2015 now oil prices are unsustainably low.
There are plenty of signs that oil prices have now fallen to a level that cannot continue over the medium and long term.
U.S. oil production is forecast to decline more than 1 million barrels per day by September 2016, according to the U.S. Energy Information Administration (“Short-Term Energy Outlook” Nov 2015). U.S. shale oil and gas producers reported losses totaling $24 billion in the third quarter of 2015, up from $15 billion in the second quarter, despite continued efforts to cut costs and improve efficiency.
Total non-OPEC oil production is expected to decline by 600,000 barrels per day next year, according to the International Energy Agency (“Oil Market Report” Nov 2015). By contrast, global oil demand has increased by 1.8 million barrels per day in 2015 and is predicted to rise by another 1.2 million barrels per day in 2016.
Shale and non-shale oil producers have been able to cut costs and improve efficiency in response to the price plunge but producers may be running up against the limits of what they can do in the short term.
The major international oil companies are presently failing to cover the cost of capital investment, debt payments and dividends to shareholders from current cash flow. “Forty-dollar to fifty dollar oil prices don’t work in this business,” the chief executive of ConocoPhillips told the Wall Street Journal (“Low oil prices catch up with the U.S. oil patch” Nov 20).
“We’re really reaching the limit of what people can do,” the chief executive of data vendor DrillingInfo said in the same article. “Right now, you are down to the best areas, the best rigs, the best people. Any cuts from now on are bone rather than fat.” Massive losses being reported by U.S. shale firms tell their own story: prices have fallen faster than shale firms can cut costs and the entire sector is running out of time and money.
There is no doubt the current low level of prices, with Brent below $45 and WTI flirting with $40, are not sustainable.
The question is when rather than if the market must eventually move higher.
The problem is that disequilibria can persist, and even get worse, for a considerable period of time before the inevitable correction occurs.
The oil market’s underlying supply-demand imbalance got progressively worse between 2012 and 2014, but a series of supply disruptions (Libya, Iran, Iraq, and Syria) masked the unsustainable trajectory until July 2014. The same could now happen in reverse, with a series of supply increases (post-sanctions Iran, non-OPEC fields planned before 2014) masking the unsustainable slowdown in supply and acceleration in demand.
Most commentators think the market will be under-supplied by 2018 without more investment in production, but there is less agreement on whether the imbalance will start to become apparent in 2016 or 2017. For their part, many hedge fund managers are convinced things must get worse for oil producers before they get better to force a more speedy adjustment.
Hedge funds have amassed a near-record short position in futures and options contracts on U.S. crude oil, betting that prices will fall further.
On Nov. 17, hedge funds and other money managers held short positions equivalent to 154 million barrels of oil, up from 90 million in the middle of October, according to the U.S. Commodity Futures Trading Commission. This is the third time hedge funds have established a large short position in 2015, with previous peaks at 163 million barrels in early August and 178 million in March.
Both big short positions coincided with sharp drops in prices, which were then abruptly reversed as the hedge funds tried to reduce their positions and lock in prices, sparking rallies.
In this case, many hedge funds and commodity dealing banks say prices must fall further to maximize the pain for U.S. shale producers to enforce a change of course.
But the gamble is a risky one because prices already appear stretched and the funds are betting that they can get in and out of the positions before the adjustment becomes apparent to the rest of the market.
In effect, the hedge funds are betting that they can ride the growing disequilibrium in the market before Stein’s law kicks in and forces a correction.