For more than a century, since oil was first discovered in the US in the late 1800s, the oil price has gone through cycles of stability and instability. The reasons for the instability range from overproduction, political instability in producing regions and legal decisions. In this article, the first in our series “Swings & Roustabouts” where we look at the history of the oil and gas industry and where it is headed, the focus is on the history of oil price instability, its causes and the macrotrends that it are spawning.
The oil price has a history of fluctuating rapidly based on a variety of factors. The first real price collapse happened in the 1860s after the discovery of oil in Pennsylvania. Oil and its derivatives were not yet a highly sought after commodity and supply greatly overshadowed demand. This overproduction pushed down the oil price and ushered in a period of price instability until around 1880. This is where John D. Rockefeller and his Standard Oil Trust entered the picture. Rockefeller was determined to bring stability to the oil market, and he did this by taking ownership of the entire production value chain. He created a monopoly on refining, integrated with the transport sector and was in a position to impose pricing on drillers. With Rockefeller in a position to dictate the market, the oil price entered a 30-year period of stability.
In 1911 the US Supreme Court ruled that Standard Oil engaged in anti-competitive and abusive market behavior. The monopoly was ordered to break up, and thus the stabilizing force of the Rockefeller empire was removed. For 20 years after the break-up of Standard Oil, the market entered a period of instability. By this time, oil and its derivatives had become a more sought-after commodity, especially with the rise of industrial automation and the automobile (prior to which the primary market for oil was kerosene lamps). The increased demand raised prices periodically, but the lack of regulation and enforced drilling quotas meant that supply regularly beat out demand. Towards the end of this unstable period, oil was also discovered in Texas and Oklahoma, increasing the supply of oil.
After the discovery of these new oilfields, low prices caused oil state officials to begin regulating supply. The Texas Railroad Commission (TRC) and the Oklahoma Corporation Commission (OCC) acted as the regulators of the oil industries in their states, which combined accounted for 55% of US production in 1927. Starting in the 1930s, and for the next forty years, oil state regulators imposed strict quotas on drillers to keep oil prices high and stable. A notable development within these 40 years of stability was the buildup of enormous spare production capacity in the 1950s. Spare capacity is wellhead production held off the market in periods of excess supply by a regulator or cartel members with the aim of stabilizing oil prices.
With more oil discoveries in the Middle East threatening an oversupply into the market, in the mid-1950s, almost two thirds of global oil production was held off the market by US regulators. A benefit of this spare capacity was having a cushion when international geopolitical incidents threatened global oil supply. During incidents such as the 1956-1957 Suez Crisis and the 1967 Six-Day War, the US was able to rely on this spare capacity to ensure oil supply remained stable.
In the 1960s, The Organization of the Petroleum Exporting Countries (OPEC) was formed. This brought together oil producing countries from the Middle East, South America and Africa in an attempt to regulate supply and ensure a stable oil price, as their counterparts in the US had done. Saudi Arabia emerged as the most influential producer within the group, with its actions having the biggest impact on the market.
In the early 1980s, oil markets weakened sharply due to the start-up of major new fields and a deep economic recession. Saudi Arabia stepped up and played the “swing producer” role by cutting its production from 10 million to below 3 million barrels per day, while other OPEC producers implemented trivial cuts of little significance. Saudi Arabia’s big supply cuts avoided an oil price collapse, but they alone suffered a huge loss of revenue and market share. When Saudi Arabia ramped up production in 1986 by adopting netback pricing, oil prices collapsed.
The oil price experienced a huge boom between 2003 and 2008, when demand, driven by a 6% global GDP growth and soaring Chinese demand, outstripped supply. The oil price took a hit during the recession in 2008, but quickly recovered to reach highs of $110 per barrel in 2011. During this time however, shale production increased significantly in the US, while more regions such as Brazil and Canada started producing more oil. These factors threatened to flood the market and force a downturn. The expectation was on OPEC to cut back on production to manage supply, but only Saudi Arabia was willing to do this. Saudi Arabia refused to go at it alone, and the oil price crashed to $45 per barrel in January 2015, 60% below its price just 6 months previously. The oil price continued to be forced down due to the oversupply, falling as low as $26 per barrel in February 2016.
Shocked by this drastic price depression, OPEC and non-OPEC countries like Russia agreed to slow down production to stabilize the market. Since 2016, the price has improved and stabilized to around $50-$75 per barrel. The expectation is that it will remain there for the short-term, but if history has shown us anything, it is that the oil market is not easy to predict.
The instability and unpredictability of the market has given rise to a couple of macrotrends within the industry. Two of these macrotrends are the change of focus from volume output to increased margins, and the adoption of technology.
With companies having to ensure that they can survive a price depression, cost saving has become an overarching strategy for companies across the value chain in oil and gas. While for many years, companies focused on the volume of oil or gas they pulled out of the ground, the threat of failure due to a prolonged downturn has pushed companies to focus more on the cost of production. The optimization of asset usage and processes has become an important aspect of daily operations at oil and gas companies.
Companies throughout the value chain, but specifically those on the service side, have realized that they need to hedge against any downturns to ensure that they survive. Doing more with less people and resources has become a common thread within corporate strategy in the industry. Companies are still cognizant of their volume output, but operational efficiency has taken a backseat to fiscal efficiency.
Another trend within the industry, as a hedge against the instability of the oil market, has been the increased adoption of technology within the industry. This can take the form of the adoption of on-site equipment automation, the implementation of business intelligence tools or the digitization of manual business processes.
Technology implementation allows companies to increase productivity while decreasing costs, allowing it to offer lower prices, secure longer contracts and to stay competitive. With the generational downturn in 2014, and uncertainty remaining about the stability of the market, companies are investing more and more into technology.
The history of the oil price is truly fascinating, with cycles of stability and instability being the norm for the last 150 years. Next week, we will be taking a look at where the industry is at now, and how oilfield service companies are reacting.