The Next Oil Price Crash

With all the talk of $100 or $200 oil in the near future, it’s important to remember that forecasts are never more than guesses and that almost anything is possible. M.I.T.’s Morry Adelman once compared the oil price to a fish, which could rise above the ocean’s surface, but only briefly, and never go below the seabed. The surface was the long-run marginal cost and the seabed was the short-run marginal cost. An alternative version of that came from Fereidun Fesharaki, who coined the term ‘hatrack theory’ of prices, which held that at any given time, the price could be higher or lower on the ‘hatrack’ with the same fundamentals.

Generally speaking, market psychology is a major factor affecting prices and traders tend to move in a herd. In a bull market, an increase in OPEC production will be interpreted as a reduction in spare capacity, and thus cause prices to move up. In a bear market, higher OPEC production will be seen as raising inventories and thus be expected to push prices down. Right now, the bulls are ascendant in response to market fundamentals, specifically given the sharp drawdown in oil inventories. Production increases have lately been interpreted as market tightening, as spare capacity is reduced. But, like the weather, that could change.

Price spikes can occur at any time due to rapid changes in oil supply, often because of geopolitical events such as the 2002 oil workers’ strike in Venezuela, Gulf War II, and the Arab Spring. When markets are tight, smaller incidents like the drone attack on an Abu Dhabi oil facility, can send prices up. Even threats of supply losses will move prices.

Price crashes are different, in part because demand is much more stable. Price crashes usually happen because of weakening fundamentals, as in 1986 and 2014, a conflict between OPEC members over quota adherence, as in 1998, a recession as in 2008, or a pandemic, admittedly a rare occurrence. But also, as in 2008, prices can get elevated beyond what the fundamentals justify and result in a collapse. Could that be happening now?

No, you scoff, the market is very tight with low inventories, OPEC+ underproduction and rising demand. All very true, but none is irreversible, under the right circumstances. This post will discuss those circumstances.

On the supply side, the potential for bearish (relative to prices) move is limited, especially for a sudden move. A restoration of the JCPOA with Iran would be such a move as it would quickly add about 1 mb/d to the market. The chances of a surge in production from the three OPEC+ countries with the most spare capacity—Iraq, Saudi Arabia and the U.A.E.—seems unlikely given their adherence to quotas over the past several years.

Demand is a concern, though. For one thing, although it appears that the pandemic is not yet in the rearview mirror, the world seems to be gaining ground on it. Which doesn’t rule out a new variant hitting oil demand: most of us (okay, me) thought that Delta was probably the last variant, but viruses are tricky. Still, it seems likely that the global economy will be recovering as the year progresses, all else being equal.

But, as oil trader Hamlet would say, there’s the rub. The gorilla in the room is the Fed, which seems inclined to throw poo at us (or take the punch bowl away, as the saying goes). Recently, stock markets took a hit from expectations of higher interest rates, selling on the rumor but then buying on the downdip. The potential for a significant pullback in equity markets is very real: although I have been warning of this for several years (futilely), it remains all but inevitable that there will be a major correction, which is likely to be initiated by higher interest rates.

The figure below shows what happened to demand during the 2008 recession: the drop amounted to about 325 million barrels over five quarters. The Fed could easily trigger a massive selloff in equities and slow the U.S. (and global) economy, but probably not to the degree of the 2008 recession. Given that global inventories are somewhere around 500 million barrels below ‘normal,’ even a medium recession would be unlikely to crash prices. It would speed up the return to a balanced market and moderate prices.

The other scenario is for a creeping rise in global inventories and growing surplus that would suggest to OPEC+ that prices need to be adjusted downward, as in 2014. While there is currently a focus on the shortcomings in OPEC+ production, that could change. As mentioned in a previous post, Angola and Nigeria appear unlikely to restore production for at least some months, even if they began such an effort now. On the other hand, Venezuelan production has increased about 500 tb/d over the past year, and this could continue.

The table below provides rough estimates of the possible inventory impact for 2022 of different changes as described above, with my guesses, I mean, judgmental forecasts, of the changes in million barrels. It is important to note that the various factors are independent of each other: there’s no correlation between Iranian and Libya production, for example, or a recession and U.S. shale production. Thus, the totals for the optimistic and pessimistic scenarios are definitely low probability scenarios

Again, global oil inventories are approximately 500 million barrels below normal and will probably build relatively slowly, at least in the first half of the year. The only things that could cause a moderate downward bump in prices, say $10 a barrel, would be either the advent of a recession or renewal of the JCPOA with Iran, allowing renewed exports. Either could happen in the next few months.

The other factors, such as rising shale oil production, increased ‘leakage’ from Iran and/or Venezuela would have a gradual impact as the year progresses. However, by the third or fourth quarter, without robust demand growth, they could threaten the demand for oil from OPEC+ and, especially if shale oil seems likely to continue growing at a good clip, up to 100 tb/d/month, it is possible that the core OPEC members will conclude that they need to repeat 2014. If prices are $70 then instead of the current near $90, the price drop will be more moderate, but if they are still at $90 as inventories are surging, then a $20-30 price correction is more likely.

Ultimately, I would recall the words of J. P. Morgan, who when asked how he made money on the stock market, replied, “I always sold too soon.”