Oil Isn’t Cheap But It Might Become So

The internet is filled with claims that oil is undervalued compared to, for example, gold prices, the stock market, historical levels and so forth, even as the President calls for prices to fall further. Many of those arguing prices are cheap appear to be price bulls who are relying more on financial indicators than market fundamentals or basic microeconomics, but others point to factors such as low surplus capacity in OPEC and a possible decline in shale oil production.

Claims that oil is cheap are reminiscent of past comparisons, often nonsensical, such as noting that oil is cheaper than Coca-Cola or Jack Daniels. That is very true but you would hardly substitute gasoline for either drink or put those substances in your car’s engine. The implication is that ‘cheap’ is in the eye of the beholder, but that is an oversimplification.

Yes, prices could rise and rise sharply in coming months especially if the global economy booms, sanctions are tightened against Russia and Iran, and/or OPEC+ decides to cut production significantly. Any or all of those might happen, but they might not also and oil price wagers are thus dependent on a number of unpredictable political moves, even aside from uncertainty about the economy.

Modeling oil prices has a relatively long history, mostly from the 1970s onwards because prior to that they tended to be relatively stable, thanks to the Seven Sisters and the Texas Railroad Commission. After 1973, oil price uncertainty grew and combined with the increased availability of computing power, an industry grew up around modeling and predicting the price. Interest in the effort grew as oil futures became available to trade in 1983, and later in 2005 when exchange traded funds (ETF) were introduced. This meant that the market participants were no longer just oil companies and large oil traders but bankers and then individual investors. The market for insight soared.

But the growing ease of statistical analysis was its own problem: many analyzing and writing on oil prices were novices to statistical analysis. This often led to grievous errors, such as throwing in lots of variables to get a good ‘fit’ or correlation, not realizing that doing so virtually guarantees what looks like good results even when counterintuitive. Famously, stock market moves historically correlated with aspirin sales, prevalence of yellow in fashion and even the length of women’s skirts, which some tried to explain as being causal in some way. A bad stock market meant more aspirin sales, was one hypothesis.

Which highlights a second analytical error namely assuming correlation equals causality. In a given time period, oil price trends might resemble stock or bond values, gold prices, natural gas prices, and many other factors, but as time passes, the relationships tend to break down. Cherry-picking the time period analyzed, intentionally or not, leads to erroneous conclusions about what moves oil prices.

The degree to which oil is ‘cheap’ or not confuses many. Economists will say that the value of something is whatever the current price is, but that is not very illuminating. Comparing the existing price level with any given historical period is informative, but hardly definitive as to the ‘appropriate’ price level. Still, it makes a good jumping off point and the table below breaks down the primary historical oil price cycles.

Oil Price Cycles

From 1861 to 1972, the average oil price was $34 (all prices converted to 2024 dollars) as the table shows. This was not the competitive price as major oil producers (the Seven Sisters especially) restrained production to keep prices ‘high’. The market price only appeared low because the taxes paid to the oil exporting governments were very low. When OPEC gained market power in the 1960s, combined with two supply disruptions in 1973 and 1979, the price bumped up 50% to $55/barrel for the 1973 to 1985 period, which might best be described as an oligopoly price.

But then 1986 to 1998 saw a reduced price as OPEC members, notably Saudi Arabia, recognized that the price was unsustainably high and increased production, allowing them to regain some market share (Figure below). However, some members still restrained production to conserve resources. Resource nationalism in many countries was a major factor as well, as governments reduced or avoided foreign investment in their oil resources. This helped to keep prices slightly elevated compared to the pre-1973 price. Even so, prices remained below the previous period (1973-1985) despite numerous voices insisting they were unsustainably low.

But the price collapse in 1998 was a different animal from the one in 1986, falling from a relatively low price of $32/barrel to an abysmally low price of $18/barrel. While it was argued that the 1986 price collapse would restrain investment and thus production, the reality was that non-OPEC managed to grow, as prices after 1985 were still above the historical average. The same was not true of the 1998 oil price collapse, which caused a significant pullback in non-OPEC drilling. Combined with the economic boom in China, followed by supply disruptions in 2003 and 2011, prices stayed well above the pre- and post-1973 average from 1999 to 2014. To many, $100 a barrel was the new price floor because that was supposedly the cost of the marginal barrel.

Conventional oil supply during this time did not decline as many peak oil advocates predicted but continued to grow, even as shale oil supplemented it. Prices remained high compared to either the pre-1973 period of the 1986-1998 because of lost supply from Iraq (non-reversed), Venezuela (self-inflicted wound), Iran (sanctions) and Russia (sanctions). The post-pandemic era saw prices recover as OPEC+ shut in about 12 million barrels a day at the peak in 2020, a reduction that is now largely undone.

Oil is one of the few commodities that has shown a tendency to increase over the long term. This is misinterpreted as resulting from depletion, that is, the constant movement from higher quality resources to lower quality resources: smaller, deeper fields is the cliché. The reality is that short-term disruptions have caused price spikes, while longer term, it is the political decision to restrict investment and production by many resource-holding countries, compounded recently by sanctions against some producers, most notably Iran and Russia, that has kept prices above the pre-1973 average.

Aside from the current market situation, what will determine oil prices during the next long cycle? The bullish case relies on the belief that high decline rates in existing fields combined with demand growth and continued sanctions and/or voluntary production restrictions will keep markets tight, enabling prices to be $75 to $100/barrel or more for years to come. This is certainly one possible scenario, but the effect of high decline rates in driving production down has been exaggerated.

More tellingly, there appears to be an increasing shift from resource nationalism to resource rationalism. In political science, general systems of belief are called regimes: resource nationalism could be considered a regime when it is widely accepted as an optimal policy. However, the current signs suggest that the regime might be flipping more towards resource rationalism, that is, exploiting resources for economic gain and depoliticizing investment, rather than trying to maximize per-barrel revenue.

The evidence includes the aggressive upstream investment programs in two major OPEC members, Iraq and the U.A.E., both of which have been adding capacity even as the market has been weakening. Further, the three resource rich countries under sanctions—Iran, Russia and Venezuela–will almost certainly want to raise production once sanctions are weakened or removed. They could add millions of barrels a day of production capacity in the years following the removal of sanctions, although the timing is extremely uncertain.

Two other changes are even more suggestive that attitudes might be increasingly influenced by the ‘Abundance’ political philosophy rather than resource nationalism. In Argentina, oil production has doubled in five years thanks largely to fracking of the Vaca Muerta shale. While it is true that the U.S. industry has extremely favorable characteristics that drove the oil shale revolution, including private mineral rights and a competitive oil field services industry, Argentina has overcome those handicaps to become the latest success story in shale oil production. This should encourage others to follow its example, which could unleash large volumes of shale oil around the world, albeit more slowly than the U.S. shale boom.

Indeed, Argentina’s success with fracking might explain the recent policy reversal by Mexico’s government. President Sheinbaum’s predecessor and political ally AMLO banned fracking in keeping with the views of most political liberals globally, but the government this summer published plans to exploit its unconventional resources, thought to be very large. While nations in Europe which have adopted politically-based bans on fracking are unlikely to reverse them, others around the world could become significant sources of incremental supply.

The implication of a more favorable political climate for petroleum investment is certainly for price moderation, probably not unlike the 1986-1998 period, with levels close to $55/barrel rather than $100. Volatility will remain, but renewed political suppression of investment and production, the global economy should benefit from a new era of cheap oil.