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Anchors Aweigh: $26 Oil As Your New Starting Point

China, Company Strategy, Economics, Oil & Gas
By John Richardson on 05-Feb-2016

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By John Richardson

IF not these six months then it will be the second half of this year and if not H2 then definitely, without a doubt, sometime in 2017.

So goes the constantly shifting thinking of some oil, gas and chemicals companies, and some of the independent analysts, on when oil markets will rebalance to “rational price levels”. They may no longer define rational as $100/bbl, but they still see prices recovering to above $50/bbl.

But, actually, when you discount two relatively short and exceptional periods of history, the above chart shows us that the average price of oil, adjusted for inflation, from 1861 until 2016 is just $26/bbl.

Why, therefore, are some people still holding on to the idea that prices must inevitably rise above $50/bbl?

This is partly due to too-rigid definitions of what it costs to produce a barrel of oil.

In the US, for example, costs keep on tumbling because of the strong economic imperative to push constantly hard on innovation. Not surprisingly, for instance, some of the wells in Reeves County in Texas make economic sense at just $14/bbl. Why shouldn’t this expertise spread across the US as a means of creating jobs, especially now that the crude export ban has been lifted?

Many of the world’s state-owned oil assets have low breakeven costs. Take Iran as an example where its production costs are just $1.70/bbl.  Add the economic imperative, like the US, of pumping oil as hard as possible and you could well end up with Iran greatly adding to today’s oil-price deflation. In Iran’s case, it is of course anxious to make up for many years of lost growth now that sanctions have been lifted.

Throw Saudi Arabia’s now long-standing decision to chase market share rather than price into the mix (and, of course, Saudi too has very low production costs) and you have another reason why these old Excel models no longer work.

Here is another major reason why yesterday’s thinking on crude is wrong: Analysing demand growth in general has for many years been outsourced to external organisations such as the IMF and the World Bank.

During the economic Supercycle this was fine as if you got growth slightly wrong it didn’t’ really matter. When recessions did happen, they were brief and very short-lived, thanks to the Babyboomers and China. But the economic Supercycle is over.

The debate over whether or not climate change is man-made is also over. It doesn’t matter what you think and what your politics are. If you are fervently against the view of most scientists forget it, you have lost. You must instead accept that we are irreversibly into an era of greater fuel efficiency, and of a gradual shift away hydrocarbons towards renewables.

The environmental issue must also be thought of in terms of not just global warming, but also of air quality and the immediate consequences for human health in countries such as China. Reducing particulate matter, through switching electric cars whilst also restricting new sales of petrol and diesel-driven vehicles, is a major political priority.

Yet another problem behind the old world thinking on oil is timeframes. Most of today’s Excel models are built on the assumption that the last ten years of history can be extrapolated forward, to a view on oil prices in 2026 and beyond.

This is where the concept of “anchoring” helps, which is best explained by the Nobel Prize-winning psychologist Daniel Kahneman. This is the common human tendency to rely too heavily on the first piece or pieces of information offered (the “anchor”) when making decisions.

You start work as a junior oil analyst in 2007 and the first thing you read is that oil prices are $100/bbl. This becomes your anchor and colours your later judgements.

Alternatively, you are an “old hand” who has simply forgotten that $100/bbl is a very recent phenomena. So you are also cognitively biased, or anchored, on oil at that price and this influences all your subsequent number-crunching.

Thus, you say to yourself: “OK, I accept I was wrong last year when I said that the long-term average price of oil must get back to $70-80/bbl. But now I feel that prices simply must reach $50-60/bbl”.

All the time the “anchor” of $100 is in the back of your mind. Your tendency is to therefore always push your forecasts as close as possible to that number. But as the facts on the ground constantly change, as close as possible become an ever-lower number.

As Paul Hodges, though, points out in the latest issue of his excellent PH report,  you don’t have to look that far back in history to a time when the world was very different:

  • Until 2005/6, nobody could imagine that prices would ever rise above $30/bbl, in the absence of an OPEC‐induced ‘shock’ as in 1973 and 1979.
  • Lord Browne, then CEO of BP, caused major controversy in May 2005 by suggesting that oil prices might temporarily rise to $40/bbl.

And again look at the chart at the beginning of this post: The average price of oil from 1861 to 2016, barring two very unique and brief historical periods, is $26/bbl.

Everyone needs to let go of their anchors and think again.