How oil could go even lower

The world is well into a prolonged period of boom-bust oil prices, the third in its history. This bust phase will send oil prices a lot lower than consensus expects. We see Brent averaging $38 next year, on the low end of forecasts, but that implies weekly or monthly prices easily into the $20s.

That projection also assumes healthy GDP growth. Considering what the International Energy Agency called an "exceptionally precarious" macroeconomic outlook next year, our low-end price expectations may be too high. But after the bust comes the boom: Expect soaring crude prices later this decade as demand from fast-growing Asia collides with greatly diminished supply — a classic bust-boom cycle with which the oil industry was all too familiar 100 years ago but may have forgotten since.

Andrew Cullen | Reuters

An oil pumpjack operates near Williston, North Dakota.

Some historical perspective helps to understand today's wild oil price behavior. Since Edwin L. Drake's first commercial oil well in 1859, crude prices have been naturally prone to wild boom-bust price swings. For most of oil's history, someone has tried to regulate supply to stabilize the price because neither industry nor governments enjoy volatility in a commodity that is the lifeblood of modern civilization. John D. Rockefeller's Standard Oil Trust was the first regulator, monopolizing refining and integrating with pipeline and railroad companies. Boom-bust prices followed the Standard Trust's demise in 1911. From the early 1930s until 1972, U.S. oil states imposed oil supply quotas so restrictive they would make OPEC blush, while major international oil companies, or "The Seven Sisters" held back oil supply from the massive Middle Eastern concessions they operated. OPEC took over as the supply regulator in the early 1970s but succeeded only when Saudi Arabia was willing to play swing producer, bearing the brunt of supply cuts or increases to balance the market.

OPEC's grip started loosening 10 years ago. Brent's mega-price spike in 2008 to $146 a barrel, followed by the fastest-ever collapse to $36 six months later, was a symptom of OPEC having lost control of the price ceiling. And the 67 percent price swoon since the summer of 2014 demonstrates OPEC will not impose a price floor.

Figure 1: Nominal market prices for U.S. crude oil

The question now is: Where does crude bottom and how? Here are three scenarios to consider.

First, oil prices crash fast and far enough that OPEC and some non-OPEC producers are spooked into emergency cuts. This occurred after shock-price implosions in 1986 when Brent fell to $9 per barrel (Riyadh deliberately flooded the market), in 1998 when Brent crashed to $10 (OPEC failed to see the Asian crisis coming and increased quotas as demand was falling); and in 2008 at $36 (amid the Great Recession). So far there is no sign OPEC members, much less Russia or other non-OPEC producers, are prepared to contribute voluntary cuts. Intense geopolitical rivalries and proxy wars also complicate any deals to share the burden of supply cuts.

A second bottom scenario entails geopolitical conflict or societal upheaval that disrupts oil supply. There is one historical example: Saddam Hussein's decision to invade Kuwait in 1990 stemmed in large part from Kuwait's flaunting of OPEC quotas. Today, Venezuela is deemed to be the most vulnerable to societal collapse, though we assess an oil disruption there to be unlikely. Other candidates include Iran, which could rev up non-state proxies to further destabilize or even disrupt Saudi oil facilities; And Russia, who's deeper involvement in Syria has aggravated tensions among all the major players in the region, especially Saudi Arabia, and will remain a significant driver of geopolitical risk across the Middle East.

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The third price-bottom scenario would see producers with high operating costs collapse under low prices. The most vulnerable producers are U.S. stripper wells. Totaling at least 700,000 barrels per day, these small wells would begin to shut down if crude ranged around $35 for at least six months. However, stripper well owners are likely to continue pumping until a maintenance issue arises that would force a shut down. Significant shut-ins would only appear after months-to-quarters of lower prices. More often than not, stripper well shut-ins are permanent due to various geological and mechanical factors, reinforcing their owners' reluctance to shut them off. Other candidates are Canadian tar sands; North Sea and Russian brownfield supply (which depends on continuous capex to arrest steep decline rates); and of course shale oil output, which is in the process of rolling over, with declines likely to accelerate.

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The current low price environment is not likely to last as long as the one that settled in after 1986. Back in the 1980s, demand was destroyed structurally (especially the displacement of fuel oil in electricity generation and space heating) and permanent efficiency gains were baked in. Looking forward, oil demand is expected to grow robustly in China and other emerging Asian nations, as well as from fast-growing countries in the Middle East, Latin America, and Africa. On the supply side, the ongoing price bust is leading to massive delays and cancellations in new projects. In July, Wood Mackenzie reported oil and gas companies have delayed some $200 billion of investment in more than 45 projects, exclusive of U.S. shale, due to the price slump. More than half of affected reserves are in deep-water projects, and nearly 30 percent are in Canadian oil sands. In September, Wood Mackenzie predicted 140 of the 330 fields in the UK North Sea could close in the next five years, even if oil prices recover to $85 a barrel. Some 5 million b/d of supply has been deferred or canceled. This means supply that had previously been expected to become available in 2018 or 2019 will not be there.

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A third difference between now and the 1980s is that OPEC spare capacity was much higher back then (17 percent of world demand compared with around 1.5 percent today). Spare capacity, Saudi Arabia's vice minister for petroleum Abdulaziz noted, "is key to maintaining oil price and global economic stability," and the oil industry "is one of the few industries in the world that is operating at such a thin cushion."

Thus toward 2020, barring a deep global recession, global oil demand growth will eventually whittle away the inventory surplus and then collide with meager, insufficient supply capacity growth. Should world GDP grow anywhere close to the IMF's medium term forecast in the high 3 percent range, oil demand growth will rise by closer to 2 million b/d than 1 million b/d by our reckoning. But on the supply side, all that may be available will be whatever limited Saudi spare capacity exists, additional production that troubled producers like Iraq and maybe Iran can add, and uncertain contributions from U.S. shale companies, whose executives, lenders, and workers will have been burned by the price implosion underway.

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Commentary by Robert McNally, founder and president of The Rapidan Group, an independent energy-consulting and market advisory firm based in the Washington, DC, area. From 2001 to 2003, Mr. McNally served as the top international and domestic energy adviser on the White House staff, holding the posts of Special Assistant to the President on the National Economic Council and, in 2003, Senior Director for International Energy on the National Security Council. He is a Fellow at Columbia University's Center on Global Energy Policy and the author of the forthcoming book "Missing OPEC: The History and Future of Boom-Bust Oil Prices," from Columbia University Press, 2016. Follow him on Twitter @andourposterity.