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Saturday, January 16, 2016

Crude can be cruel – Redux of 1985-86 ?

Saturday, 16 January 2016
Crude can be cruel – Redux of 1985-86 ?

BEFORE we could even put a finger on where crude oil prices eventually head, it’s worth re-looking some of the crisis period for oil prices.

There were three large oil price declines before the current one, in 1985–86, in 1990–91 during the first Gulf War and in 2008–09 during the global financial crisis.

When oil prices collapsed in 1986, it occurred following several years of high prices, precipitated by the 1979 revolution in Iran.

The price of Saudi light was set at US$34 a barrel in 1981 by Organisation of Oil Exporting Countries (Opec).

However, high prices and a global recession in the early 1980s led to a large decline in oil consumption, mainly in advanced economies, which induced fuel conservation, substitution of other fuels for oil such as electricity generation and efficiency gains, particularly higher minimum fuel efficiency standards for automobiles.

This period also witnessed the rise of non-Opec producers, Alaska in the United States, Mexico, and in the North Sea. Weak demand and rising non-Opec output forced Opec to cut its production nearly by half, absorbed mainly by Saudi Arabia.

Saudi Light crude eventually declined to US$28 a barrel in 1985, on the back of sluggish global economic activity and the decision by several Opec members to discount official prices to increase exports.

By 1985, Saudi Arabia’s oil production dropped to 2.3 million barrels a day from 10 million a few years earlier. To regain market share, it raised production, abandoned official pricing, and adopted a spot pricing mechanism.

Two notable policy decisions, Opec’s ability to absorb excess crude oil to maintain a certain level of crude oil price and the other the increased production from non-Opec producers. Production from Non-Opec economies was significant in keeping prices lower, overwhelming the cartel’s ability to influence the overall price of crude oil.

The 1990-91 oil crash was very much a geo-political event, it was the indirect result of Iraq’s August 1990 invasion of Kuwait.

Oil prices were low for a number of years before the invasion, with North Sea Brent averaging less than US$17 a barrel over the previous five years.

Iraq’s invasion of Kuwait and the subsequent Iraq war to restore Kuwait’s independence took out more than 4 million barrels a day of combined Iraqi and Kuwaiti crude oil from the market.

Other Opec members had more than enough untapped capacity to cover this shortfall, but it took time for them to ramp up output, so prices rose sharply. Brent prices briefly rose above US$40 a barrel in September 1990 before gradually retreating to US$28 in December as additional supplies reached the market.

By mid-January 1991 however oil prices were crashing in a sharp and sudden manner, with the International Energy Agency (IEA) indicating that advanced economy members would release 2.5 million barrels a day from the emergency crude oil stocks they held in reserve. The quick resolution in ending Iraqi control of Kuwait and the excess supply being released by IEA was sufficient to push crude oil prices under US$20 a barrel.

Once again, note the influence of non-Opec producers, namely the IEA in driving prices lower via increasing supply. The influence from non-Opec producers gained traction in markets, implying Opec’s ability to influence the direction of oil prices was gradually waning.

The 2008–09 price decline was a response to the global financial crisis that began in 2008. During the second half of 2008, oil prices fell more than 70%.

The collapse reflected global uncertainty and a drastic reduction in demand. But this decline was a general decline in the commodity complex itself, as energy products, coal, metals, food commodities and agricultural raw materials all fell.

The severity of the 2008 oil price collapse had its roots in Opec’s very decision in the early 2000s of restricting oil supplies, where Opec decided to target crude oil price range within a band of US$22 to US$28 a barrel.

However, when prices exceeded that range in 2004, Opec raised its preferred target to eventually reach US$100 to US$110 a barrel. As the financial crisis unfolded and recession gripped the advanced economies in 2008–09 period, prices dropped to less than $40 a barrel.

Within 24 months, prices surged back to the US$100 mark, aided by stronger demand as the global economy rebounded as well as supported by Opec’s decision to reduce supply by 4 million barrels a day.

While weak global demand pushed crude oil prices lower, the rebound via Opec’s mechanism to control supply and manage price levels, renewed confidence towards the cartel, implying Opec members were back in control in managing the direction of crude oil price. This has been the case since, until the current crisis in crude oil prices unfolded.

The obvious pattern seen over the past few crisis on crude oil prices show that the relentless power play between Opec members and non Opec producers.

The current decline in crude prices, is a redux of the 1985-86 period but with a twist. What started off as the shale oil boom, that became a viable substitute to crude oil, has instead turned out to be an event that has forced Opec members to curtail supply. Though crude oil currently trades way below the breakeven prices for shale oil, the damage has been done.

It would take more than purely a curb in production by Opec to lift crude oil prices higher, it would need a sharp rebound in global demand itself for crude oil prices to normalise, but the big question what is normal prices anyway for crude oil?

Dr Suresh Ramanathan is an independent strategist. He can be contacted

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