Oil Prices - Back to the future

Can you believe that it is possible to buy oil at $3 per barrel? Well yes…. The only qualification is that you would have to transport yourself back to the 60s! Doesn't seem that long ago, does it? The oil prices then recently surged through the $28 per barrel frontier to touch new highs in the $30 plus territory. The last time this happened was in the early 80's during the Iraq Iran war. So what happened now that has pushed up the Oil prices by 80 percent in a few short months? How and why did the prices rise so fast and more importantly will they sustain at these high levels or will they come down to more realistic levels?

Pre Embargo Period, Crude Oil prices ranged between $2.50 and $3.00 from 1948 through the end of the 1960s. If viewed in terms of the 1996 dollar, have crude oil prices fluctuated between $14 - $16 during the same period. The apparent price increases were just keeping up with inflation. From 1958 to 1970, prices were stable at about $3.00 per barrel, but in real terms the price of crude oil declined from above $15 to below $12 per barrel.

OPEC was formed in 1960 with five founding members - Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. By the end of 1971, six other nations had joined the group: Qatar, Indonesia, Libya, United Arab Emirates, Algeria and Nigeria. In March 1971 the balance of power shifted from USA to OPEC. That month, the Texas Railroad Commission set probation at 100 percent for the first time. This meant that Texas producers were no longer limited in the mount of oil that they could produce. More importantly, it meant that the power to control crude oil prices shifted from the United States (Texas, Oklahoma and Louisiana) to OPEC. In 1972, the price of crude oil was about $3.00 and by the end of 1974 the price of oil had quadrupled to $12.00. This was due to the Yom Kippur War between Israel Syria and Egypt, in which the strong support of the western world for Israel led to an embargo by oil exporting nations. Arab nations curtailed production by 5 million barrels per day (MMBPD). The extreme sensitivity of prices to supply shortages became all too apparent. Prices increased 400 percent in six short months. From 1974 to 1978 crude oil prices increased at a moderate pace from $12 per barrel to $14 per barrel. When adjusted for inflation the prices were constant over this period of time.

Crises in Iran and Iraq led to another round of crude oil price increases in 1979 and 1980 which resulted in crude oil prices more than doubling from $14 in 1978 to $35 per barrel in 1981. But OPEC nations learnt that unrestrained price rises had their own fallout in terms lower rates of consumption, automobiles which would have had higher mileage and homes and commercial buildings which were better insulated and improvements industrial energy efficiency. All these were greater in periods of oil price hikes and led to curtailing of consumption.

Another weakness in the OPEC set up was its ineffectiveness as a cartel. Though some members understood that the reactions to oil price hikes (mentioned above) were not of a temporary but a permanent nature, which meant that when the prices of oil eventually fall demand would not pick up in the same proportion thereby leading to a crash in the prices, they were unable to convince other members to regulate production. Setting of production quotas to stabilize prices met with repeated failure. In August of 1985, the Saudis linked their oil prices to the spot market for crude and by early 1986 their increased production from 2 MMBPD to 5 MMBPD resulted in Crude oil prices plummeting below $10 per barrel by mid year.

Throughout the late 80's the price of crude remained depressed but spiked in 1990 with the uncertainty associated Iraqi invasion of Kuwait and the ensuing Gulf War. Post that, crude oil prices entered a steady decline until in 1994 inflation adjusted prices attained their lowest level since 1973. The price cycle then turned up. With a strong economy in the United States and a booming economy in Asia, increased demand led a steady price recovery well into 1997.

But the impact of the financial crisis in Asia in 1998 was underestimated by OPEC. In December 1997, OPEC increased its quotas by 10 percent but the rapid growth in Asian economies had come to a halt. So even though the demand had fallen the supply continued to grow. In addition, a million barrels a day of additional Iraqi oil came into the world oil market over the course of 1998. Storage facilities filled to the brim. Prices collapsed with oil selling for $10 a barrel and talk of prices heading to $5 per barrel.

In March 1999, the OPEC met with the prime objective of reducing inventories by reducing production. The prospects of the further reduction in price were dire enough to lead not only to new restrictions on production but to a surprising degree of discipline and compliance. Officially, the exporters--led by Saudi Arabia, Mexico and Venezuela--agreed last March to produce 2.1 million barrels a day less, on top of 3.2 million barrels a day of cuts they had made in 1998. Actual compliance between 65% and 90% was more than enough to squeeze the surplus out of inventories and bring them down to 1996 levels.

But today, that success has become their problem. Many of them recognize that if prices get too high, then they too will feel the impact--from inflation and economic slowdown, which affects them directly and indirectly through reduced oil demand, and from the weakening of global equity markets, in which they are increasingly vested.

But in late 1999, with supply and demand again going in opposite directions due to accelerating demand, as Asia rebounded and the U.S. economy continued its expansion, the prices have gone through the roof. Also cold weather, logistical problems in the production and transportation of oil contributed to the hike.

The producers are still talking tough in terms of increasing production and are intent on recovering the revenues that they "lost" during the collapse. But they also realize that prices at these levels are unsustainable for a number of reasons. Firstly high prices would tempt exporters to cheat on the production quotas and would encourage non-OPEC supply. Secondly most oil-producing nations recognize that any extended period of high prices threatens their own interests and could contribute to a global economic slowdown, which would cut into demand. And thirdly this rampant hike could cause strains in the relations between oil-producing states and the West. Fourthly expectations in the short run about Asia's recovery seem to be again overstated and will really take place when China and Japan, the two engines of Asian growth, undertake structural reforms.

So the hike will not sustain. But every time the demand supply mismatch has favored demand, a new floor price is set. OPEC has indicated that its objective is to keep prices within a band of $22-$28/bbl. If prices should fall below $22/bbl, production would be cut by 500,000 b/d; if prices rise above $28/bbl, production will be comparably increased. They are also keen on devising a mechanism to avoid a price crash. For example, one million barrel per day imbalance can move the market 3-5 dollars per barrel. That is only a little over a one percent of world production. But a gradual increase in production, taking into account the transportation period, will ensure that inventories are shored up over a period of two to three months. This will help to bring down oil prices to more realistic and sustainable levels.

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