Why Oil Prices Will Go Back Up

It's Ugly Right Now

Due to the fact that I live in one of the world's most prolific oil-producing regions, Alberta, oil prices are a constant topic of conversation. Over the last year oil prices have been low and that has had a tremendous impact on the economy. According to the provincial government, real GDP growth in 2014 was an incredible 4.8% but in 2015 Alberta has experienced a recession and according to the economist in the office next to mine (Todd Hirsch) Real GDP growth will be -0.7% this year.

Obviously, going from one of the best economies in the developed world to a recession comes with some hard realities. I recently read that mass layoffs alone (layoffs of more than 50 people have to be reported to the government) were now over 18,000 this year and housing prices in Fort McMurray are down over 20%. So suffice it to say that times are tough in Alberta.

This Time is Not Different

Source: Statistics Canada Cansim Table 384-003

With all that said, what drives me crazy about the lower oil prices is how many people keep saying that this time is different. I was born in Red Deer, Alberta in 1986 and for literally my entire life the energy industry in Alberta has gone through cycles that are best described as 'boom and bust'! The chart to the right shows these cycles.

I keep hearing that it's different this time because Saudi Arabia isn't stepping in to reduce supply or it's different because the shale oil producers in the US can produce oil cheaper than us, or it's different because Obama, Trudeau and Notley won't approve any pipelines. While all these things might be true I don't believe that makes this time different. Every time oil prices decline there is a different cause and every time they increase again it's for a different reason as well.

In the late 1980's the drop was attributed to growing production in non-Opec countries, the decrease in the late 1990's was due to the economic crisis in Asia, and the drop in the early 2000's was from a weakened US economy and September 11th. The price increase in the late 1980's was due to conflict in the Middle East and the Gulf War and the increases in the mid-2000's were because of increasing demand in Asia and speculation. Every time there's a big change in price there's a different reason but as far as I'm concerned they're more alike than they are different.

The chart below shows global oil production, consumption and the benchmark price (WTI). Hopefully what strikes you about this chart is how close production and consumption are. When I read the news everyday and see that the price of oil is down over 60% I'm left with the impression that we are awash in oil. I don't necessarily think we have 60% more oil than we need but I'd think it's a lot and I'm guessing most people think so too. However, if you actually look at the numbers (and are really generous with how you round) the world is currently oversupplied by 3%....

Source: EIA and usinflationcalculator.com

So What's Up With the Price

Given the huge discrepancy between the price drop and the amount of oversupply it's pretty natural to think that the price makes no sense. In economic theory though I'd argue it makes perfect sense and in the next paragraph I'll explain why.

If you google something called "the paradox of value" you'll see that even Adam Smith (considered the founder of capitalism...) struggled with how things are priced. His typical example was to consider why diamonds are more expensive than water but I'll illustrate the concept here with another story by  Eugen von Böhm-Bawerk (that I found on wikipedia) about a farmer having five sacks of grain:

With the first, he will make bread to survive. With the second, he will make more bread, in order to be strong enough to work. With the next, he will feed his farm animals. The next is used to make whisky, and the last one he feeds to the pigeons. If one of those bags is stolen, he will not reduce each of those activities by one-fifth; instead he will stop feeding the pigeons.

So the value of the fifth bag of grain is equal to the satisfaction he gets from feeding the pigeons. If he sells that bag and neglects the pigeons, his least productive use of the remaining grain is to make whisky, so the value of a fourth bag of grain is the value of his whisky. Only if he loses four bags of grain will he start eating less; that is the most productive use of his grain. The last bag of grain is worth his life.

So in this example if the farmer is offered to purchase one more bag of grain he will only pay a value commensurate with the satisfaction he gets from feeding pigeons. He simply doesn't need any more grain so why would he pay more than that. It doesn't matter that even with six bags of grain 1/6th of them is worth his life - he already has that bag and he is only paying for the next bag that he really doesn't need. This is where buyers of oil are at today. They've got enough oil to meet all their needs and they really don't need the extra barrel so they are valuing it very low. If you want a shorthand way of explaining it, prices are made at the margin and that marginal barrel of oil is just not that valuable to buyers right now...

Thanks Brandon But All the Economics Made Me Bored

Well you shouldn't be because what all of this is saying is that the price of oil is very, very volatile and it won't take much for it to get back to $80/bbl+! The most recent data I have suggests that the world will finish 2015 producing 95.5 mmbbls/d (millions of barrels per day for those wondering what that meant...) and consuming 93.8 mmbbls/d - basically the world is being over-supplied by 1.8 mmbbls/d. If that over-supply were to change to even a modest under-supply the price of oil would immediately spike.

What could cause the current over-supply to become an under-supply? The short answer is: lots of things. 

• Conflict in any OPEC nation (most are producing between 2 and 4 mmbbls/d - more than enough to end the over-supply)
• A drop in non-Opec production due to the price decrease (this is already happening)
• Increased demand because of an improving global economy (not looking good but who really knows)
• Saudi Arabia coming to their senses and balancing production and supply (my favourite theory)
• Trump becoming President and starting a Holy War with the entire Middle East

Saudi Arabia, can I be serious? Aren't they the ones that got us into this mess in the first place? To answer my own questions, yes and yes..Maybe I'm giving Saudi Arabia too much credit but I think they know exactly what they are doing and it's exactly what economic theory says they should...

Are the Saudi Arabians Geniuses?

Many economists consider the oil industry to be an oligopoly. This shouldn't be news to anyone as the paper I just linked to is from 1988...but for those who aren't familiar with the term an oligopoly is a market dominated by a few sellers. What that means though is that the sellers in this market will act like they have a monopoly and attempt to maximize their profits. 

But Brandon the Saudi Arabians are clearly not maximizing their profits. They are selling slightly more oil (11.5 mmbbls/d roughly) for $40/bbl when they could reduce production (to say 9.5 mmbbls/d) and sell it for $100/bbl. I'm no math expert but 9.5 mmbbls/d x $100/bbl = $950 million/d and that's a lot more than 11.5 mmbbls/d x $40/bbl = $460 million/d! That is 100% true. Saudi Arabia is currently going against their own self-interest by selling so much oil - so why are they doing it?

The answer is found in yet another economic example called, prisoner's dilemma. I'm not going to explain the whole concept here as you can click the link to learn more but if you watched the movie A Beautiful Mind it's actually about the economist John Nash who came up with this and contributed to what they now call game theory. So what's the point, well let's consider another hypothetical situation:

If Country A produces lots of oil and Country B produces lots of oil there will be too much and they will earn $10 and $2, respectively. If both countries produce less than they can they will both do well and earn $25 and $5, respectively. The problem is that if Country A produces less and Country B produces more, Country A will earn $8 and Country B will earn $7. If B produces less and A produces more then A will earn $13 and B will earn only $1. 

This is easier to follow in a table so let's look at it that way. So the reason this is called a 'dilemma' is because A and B don't really know what eachother are going to do and that makes it interesting...They may talk beforehand (see: OPEC meetings) but they can really do whatever they want because by the time the other country finds out it's too late - hence the dilemma. 

The other unique part about this problem is that both countries have an incentive to 'cheat' on eachother. To get a sense of what I mean by that consider that it's in the best interest of them combined to both produce less ($25 + $5 = 30 whereas all the other squares are $15 or less). The problem is that if I'm Country B and I think Country A will follow our agreement and produce less my best option is to produce at the max ($7 is greater than $5 after all)! If Country B believes Country A will break the agreement and produce more it is again in their best interests to produce at the max ($2 > $1)! 

You can do this for Country A as well and again you'll find that no matter what B does they should produce at the max. So in economic speak this means that Country A and Country B both have a dominant strategy to produce at the max even though that gives them the worst possible outcome combined! Hence the dilemma...

So how do oligopolies get through this and get to a place where everybody wins? Well, collusion, threats and intimidation...basically they all meet and agree to produce less (OPEC of course meets regularly) and the leader of the oligopoly threatens the smaller players that if they 'cheat' they will flood the market and make sure nobody wins (making it a choice between $5 and $2 instead of $5 and $7). The other members of course know this is an example of cutting off your nose to spite your face but they also know the leader could actually do this and harm them.

Where this gets interesting is when the smaller players call the leader's bluff. It's still in the leaders short term interest to produce less even if they know the others are cheating (which Saudi Arabia did for many years) but they would do better in the long term if they could make everyone fall back in line. Anyway, this is where the oil industry is today. The smaller members of OPEC have been producing above their quotas for years now and Saudi Arabia is sick of it. So to make sure their threat is credible they are punishing everyone until they are willing to fall back in line. 

In my opinion Saudi Arabia has no intention of giving away their oil forever they are simply teaching everyone in OPEC a lesson and once that lesson is learned they will go back to maximizing profits by keeping prices high. The impact on the shale oil producers and Canadian companies is really just a side benefit to them of straightening out their oligopoly.

Wrap This Up Already

So to make this long post a little longer I think the over-supply in oil and the massive drop in price is actually just Saudi Arabia punishing the over-producing members of their cartel. Based on the many economics courses I have taken, what they are doing makes perfect sense to me and is exactly what I would advise them to do (by the way don't try this stuff in North America as it violates anti-trust laws!). 

Now that's a little out there and I could be totally wrong but even if I'm not oil prices will still eventually come back because non-OPEC supply will eventually respond to the price enough to drop production and the global economy will continue to grow increasing the demand. Failing all that we can all cheer for Donald Trump and World War 3...