The oil industry and oil market and supply systems are in a period of transition.
This can be stated with confidence because strong opinions and policy recommendations are presented in a wide range of media without consensus. Analyses, predictions, and observations are presented in foreign policy journals, the financial press, stock investment “special reports”, television interviews, and government reports. Many of these are by people with little or no contact with, participation in, or other involvement with, the oil industry such as free-lance journalists, Ivy League professors, think tank fellows, bankers, stock newsletter writers, and government bureaucrats.
The predictions offer a wide range of outcomes. The EIA predicts a long period of plateauing high US production rates and President Trump believes this will lead to US Energy Dominance. Others think production will decline significantly in the near future for various reasons.
Oil price forecasters try to analyze the effects of oil and oil product supply and storage variations, dollar strength, Chinese demand, the stock market, OPEC production constraints, Middle East unrest, North Korean threats, birthrates, electric car ownership, refinery efficiencies, interest rates, internet shopping, buying habits of millennials, Federal Reserve actions, and God only knows what else. The results of all these prognostications cover a wide range. Analyses and predictions by industry participants or those with sophisticated econometric models seriously analyzing data also present a wide range of results. Undertaking one’s own analysis soon leads one into a snarl of too many uncertain, unpredictable influences on the oil markets and oil prices for confident predictions.
So the oil markets can best be described as: Confused. And the outcome of this period of transition is uncertain.
In many ways, this period is reminiscent of the period from the early 1970s to 1983, a previous period of confusion, upheaval, and transition in the oil markets and oil pricing which led to significant changes in the oil industry and US foreign and economic policy. At the risk of this commentary being a bit long, an examination of that period, what led up to it, what happened, how it ended, and what the results were can offer some insight into the current situation.
Although the triggering event for the oil market turmoil in the 1970s is generally perceived as the Arab Oil Embargo of October, 1973, several converging industry and economic trends in the late 1960s set the stage to put an end to the oil market and pricing system and common oil industry business model which had been in place since the early 1930s.
In the early 20th century the concurrent widespread adoption of the internal combustion engine and invention of rotary drilling for development of deep, high-rate, high-pressure oil fields to meet the growing fuel demand caused a period of chaotic, unrestricted oil field development and uncertain, highly variable supplies and prices. In the early 1930s, several states declared martial law in the oil fields and established systems to regulate oil field development and drilling. Drilling permits were required, well spacing requirements were imposed, and production rates were constrained to meet demand – a process known as proration whereby state authorities received monthly nominations of oil purchases from pipeline and refining companies and allocated those purchase volumes to individual wells for production.
The common oil company business model was the integrated company which explored for and produced its own oil fields, processed its oil in its own refineries, and sold the products through its own marketing outlets. Some flexibility was established between companies to buy and sell oil with each other to accommodate logistical and transportation facilities and to buy oil from small independent producers. Although some of these integrated companies were quite small, around 30 to 35 were considered majors.
A priority concern of management was to have enough production to maintain refinery operation at full capacity. Therefore, the companies maintained approximately 12% to 15% surplus production capacity to use in cases of unexpected events such as field accidents, pipeline or other transport interruptions, or periods of low exploration success. Forecasts of field production and reserves were a primary management tool and considered critical competitive information and highly confidential.
United States production capacity far exceeded domestic demand in the 1930s, 40s, and 50s – through the Depression, World War II, the Korean War, and the post-war growth period. With the rapid growth of the US, European, and Japanese economies in the post-war period, however, demand grew dramatically. International sources of crude were discovered and developed, mainly by seven companies, known as the Seven Sisters: Standard of California (Chevron), Standard of New York (Mobil), Standard of New Jersey (Exxon), Texaco, Gulf, British Petroleum, and Royal Dutch Shell. The first four of these companies owned Aramco, the British were dominant in Iran, Iraq, and the Gulf States, Gulf operated in Kuwait. The first four were also active in Southeast Asia and Latin America, Shell was active in the US, Latin America, and Southeast Asia.
Despite the rapid increase of demand in the post-World War II period, international oil companies maintained surplus production capacities in the 12% to 15% range and continued to operate under the integrated company business model. Because these companies refined oil they themselves produced they were in effect buying the oil from themselves. This meant they established their own crude prices and paid in dollars – or pounds. During the 1950s growing international production capacity in low-cost countries meant foreign oil could be supplied to the US at a much lower cost than domestic production. The Eisenhower Administration, in a Cold War confrontation with the Soviet Union and fresh memories of the strategic World War II importance of domestic US oil production, realized the threat of flooding the domestic market with cheap oil and established oil import quotas to protect the domestic industry.
Quickly after WWII, the Soviet Union separated its economy, and that of its satellite countries in Eastern Europe (the “Soviet Bloc”), from free interchange with the rest of the world behind what Churchill dubbed the “Iron Curtain”. China was taken over by a Communist government and also isolated itself. The Soviet Union was a large oil producer and China produced enough for its own needs but neither participated in the world market until the early 1990s and the following discussion concerns only the rest of the world until then.
As noted above, during the late 1960s, several trends converged to end this market and price system:
1. US demand approached US production capacity and exceeded it in late 1968 or 1969. This was not widely recognized due to the cushion provided by the imported oil. US demand exceeded US production capacity plus the import quota by late 1970/1971. This was manifested in various ways, e.g.: President Nixon lifted all state proration of production on wells in Federal offshore waters in December, 1970. Import quotas were increased and then removed. American companies re-directed their exploration and growth budgets to international projects to take advantage of higher prices and lower costs.
2. Second-tier American integrated and independent exploration and production companies moved into international operations in areas not dominated by the Seven Sisters such as the North Sea and Libya.
3. The cost of the Vietnam War and other economic pressures eroded confidence in the US dollar. The Bretton Woods international finance and currency system established after the end of WWII weakened.
Moammar Qaddafi had taken over Libya. He demanded an oil price increase from Occidental Petroleum Corporation, a new company and the largest producer in Libya. To strengthen his position in negotiations with Qaddafi, Oxy Chairman Armand Hammer asked for support from the larger majors in the form of oil supplies if Oxy were cut off from Libyan supplies. In their arrogance, they refused, and Oxy therefore agreed to a higher oil price. The larger majors were then rewarded for their refusal to help Oxy with demands for similar price increases by the Middle East governments where they operated. The US Government, in its naivete, refused to support American companies in these negotiations effectively ceding control of the markets and prices from American companies to the producer countries – one of the great shortsighted foreign policy blunders.
Perceived weakness of the dollar caused many foreign governments to increase redemptions of their dollar reserves for gold. In response, President Nixon closed the “gold window” in August 1971, thus terminating US policy of redeeming dollars for gold. The resultant drop of dollar value stimulated further demands for oil price increases from Middle Eastern governments, particularly Saudi Arabia.
The Watergate Scandal increasingly dominated the attention and activities of the Nixon Administration. Henry Kissinger, as National Security Adviser and then Secretary of State, was untouched by the scandal and thus became the main American official dealing with international affairs.
Suddenly in this period of demands for oil price increases and tensions between oil companies and host governments Egypt and Syria invaded Israel in October, 1973 (the Yom Kippur War). Israel fared badly for the first four days, used large amounts of ordnance, and lost many planes and tanks. The US re-supplied Israel who turned the war around and defeated both its attackers.
In response to US support of Israel Saudi Arabia embargoed Saudi oil supplies to the US. Other Arab countries quickly joined them.
At the time, I was on the petroleum-engineering faculty at the Colorado School of Mines. We all had worked for major integrated oil companies and we knew how they operated. Our reaction was: “The Arabs are going to embargo oil to the US? So what?” We knew the companies had plenty of excess capacity and other sources and would re-route tankers; the embargo would have little effect on availability of supply in the US. Little did we know how lack of understanding in Washington of the oil industry and its supply and market system would turn this empty gesture into a major economic, political, and foreign-policy event.
The United States Government believed the embargo would cut oil supplies to the United States and severely cripple the US economy and thus considered the embargo a major and immediate threat. Kissinger energetically set about negotiating a cease-fire to end the fighting, then a peace settlement. By that time, US Government alarm had spread to the press and the public panicked over fears of a shortage of gasoline. Everyone headed to gas stations to fill the tanks in their cars and the gas stations promptly ran out of gas. The Government and the public believed that confirmed a lack of oil. The producing countries increased oil prices again significantly; the public blamed the oil companies.
With the embargo turning into an Energy Crisis I tried to determine what caused it. We had an extensive network in the industry and I started calling producers and refiners in various parts of the world – and found no shortage of oil. I then reviewed announcements during the previous five years of worldwide exploration successes; contract awards for pipelines, offshore platforms, and other major projects; and drilling programs to ascertain if a supply shortage was pending. That review indicated rapid supply growth could be expected; the spread of second tier majors and independent E&P companies internationally was very successful at discovering and developing new supplies. Conclusion: The Energy Crisis was in the misperceptions of the Government and press who teamed up to agitate the public which then caused the only shortage with a run on the gas stations. The Crisis became self-generating.
Kissinger then negotiated the end of the embargo. In the negotiations, he renewed the US guarantee of Saudi security initially granted by President Roosevelt in 1945. The Saudis agreed to end the embargo and to purchase US Treasury bonds with their profits and foreign currency reserves. In effect, this meant they would sell oil only for US dollars thus creating what is known as the Petrodollar.
The Saudis then were free to continue to increase oil prices and their ownership of Aramco until the price had increased from about $2.50 to $15 per barrel, about 6-fold, and the American companies were out of Aramco and the name was changed to Saudi Aramco. Other producing countries followed. The erroneous perception of the impact of the embargo by the US Government thus resulted in loss of control of the international oil industry, oil markets, and oil prices by the Seven Sisters causing one of the greatest transfers of wealth and loss of power in history.
Kissinger later realized the results and I repeat his comments:
“The structure of the oil market was so little understood that the embargo became the principal focus of concern. In fact, the Arab embargo was a symbolic gesture of limited practical importance. “ and “the embargo was an inconvenience and an insult; it did not hurt us significantly.” He also refers to the “never-never land of national policymaking” with respect to expectations of oil availability.
With the loss of any controlling oversight, the oil industry then became a disorderly free-for-all developing new supplies as fast as possible to take advantage of the much higher prices while the US Government was passing laws and regulations to deal with an oil shortage which did not exist. With loss of market management by the large integrated companies, oil was traded in individual batches, frequently tanker loads, with prices negotiated between buyer and seller for each transaction; the spot market dominated. Oil traders, about 60 to 80 of them, became the critical links in these transactions. The most prominent was Marc Rich, who had been a trader for Phibro. He established his own trading company and became known as the King of the Spot Market; he seemed always able to find supplies and arranged transactions for anybody and everybody.
In 1979, the Iranian Revolution removed the Shah from power and shut in Iranian production for a short time. Prices increased again and gas lines returned but it quickly became apparent plenty of oil was available and the second Crisis was short-lived. By the early 1980s we estimated that worldwide surplus production capacity was nearing 30% but prices continued to levitate.
The US Government had passed multiple Energy Acts, imposed 55 mph national speed limits, allocated gasoline to gas stations, established multiple levels of pricing for domestic crude production, increased mileage requirements for new cars and many other counterproductive rules and regulations which dis-incentivized development of domestic US production. Most of these were canceled by President Reagan when he took office in 1981. The results of some government actions are still with us, however: Publicly traded companies were required to report oil and gas reserves and future income therefrom, the Department of Energy was formed and oversees several national laboratories and energy research programs, and the Strategic Petroleum Reserve was established.
In November, 1982, at the Oil and Money conference in London, Rosemary McFadden, head of the New York Mercantile Exchange, announced the NYMEX would start open trading of contracts for 1000 barrels of West Texas Intermediate oil in tanks in Cushing, Oklahoma. Trading started on March 30, 1983. After a couple of years to work out the bugs and establish confidence in the trading, the NYMEX trading price became the benchmark price commonly quoted. A worldwide fungible market with open pricing was thus established; the last trade on the NYMEX determined prices worldwide. NYMEX trading was followed by contracts for North Sea Brent crude trading on the ICE in London and Brent became the common quoted price in international transactions.
With price determination by open trading, the large surplus production capacity quickly became apparent; prices softened and then crashed in early 1986. To maintain stable prices, OPEC established a production quota system which, although with some cheating, worked reasonably well and maintained oil prices within a band for 20 years as the surplus capacity was worked off. This was during a period including the US Savings and Loan crisis; the end of the Cold War and the Soviet Union; the first Gulf War; market instability and the Asian currency crisis in 1998, and the 9/11 attacks.
The Soviet Union ended at the end of 1991. In 1993, China became an importer of oil. Russia and several former Soviet republics were, and are, significant oil producers and China has become the world’s largest oil importer. These countries entered the world’s free-trading oil markets after long periods of separation with little disruption of the markets or prices.
US production steadily declined for this entire period and US oil imports steadily increased. The US became increasingly dependent on foreign sources of crude oil in a worldwide fungible market with prices determined on open exchanges. The US also became responsible for maintaining those sources of supply from an unstable part of the world. The US became entangled in unending Middle East conflicts with ongoing military commitments.
The integrated oil company business model was no longer needed with oil traded on open markets with quoted prices. Integrated companies gradually went out of business; only two of the large American majors are left: Exxon and Chevron (although some include Conoco Phillips).
In the mid 2000s world oil demand reached world production capacity for the first time in history, putting upward pressure on prices. Concurrently, operational techniques of horizontal drilling and multi-stage large hydraulic fracturing techniques were combined to develop gas reservoirs commercially which had theretofore not been profitable. In response to increased oil prices, the techniques were adapted to oil reservoirs. US oil production grew quickly and has nearly doubled. With reduced demand, US imports have decreased by more than 80%.
As mentioned earlier, a certain group of forecasts predict US energy independence for a sustained future and others predict imminent rapid decline. As someone once remarked, however, predictions are really tough – especially about the future. What we can say confidently is that the US is in a strong position currently to establish new supply and pricing relationships and remove oil supplies as a guiding factor from its considerations of its involvement in the volatility and conflicts of the Middle East. This is a period of turmoil and transition similar to the 1970s; this time our policy decisions should be based on careful consideration of actual oil industry conditions and requirements.
