The Next Oil Price Collapse





The crash in 2008 was directly tied to bubble in oil prices that occurred that year, but combined with financial contagion — equities collapsed signaling a recession and sending investors into cash. The most recent price collapse was somewhat like 1986, in that OPEC’s market share appeared to be under threat, though the danger was in the future, not the past.

Thus the likely causes of a new oil price ‘collapse’ include financial contagion, conflict among OPEC and non-OPEC producers over compliance to output reductions, and pressure on OPEC’s market share.

Financial Contagion

The 2008 oil price crash was somewhat unique, in that it represented both the collapse of a bubble that sent prices to nearly $150 and the impact of financial contagion. At the time, of course, numerous pundits insisted that the market was not in a bubble, with famed oilman T. Boone Pickens saying, “Eighty-five million barrels of oil a day is all the world can produce, and the demand is 87 million ... It’s just that simple.” He predicted in August of that year, after prices had begun declining, "In two or three years, we're going to be at $200 a barrel—could be $300 a barrel for oil.”

For its part, The Economist featured peak oil advocate and Houston banker Matthew Simmons in its July 10, 2008 issue in an article titled “The high priest of ’peak oil’ thinks world oil output can now only decline.”  Funny thing, Matt Simmons often twitted The Economist for its 1998 issue with the cover “Drowning in Oil,” which appeared just before the price of oil bottomed out. And three days after the date of Matt’s 2008 interview, the price peaked and began its long decline.  (Perhaps The Economist is the best counter-indicator of market reverses.)

Contrast that with my contrarian view in two columns on May 30 and June 2, 2008 “Investing for the oi price collapse,” where I argued, “Although a number of books and many articles have been written describing how to profit from ever-higher oil prices, not much has been said about what will happen when prices come down, as they are all but certain to do.” Commenters were nearly unanimous in their scorn at my lack of intelligence for thinking prices could decline.

Not that my track record is flawless, especially when it comes to short-term price forecasts.  Peak oil advocate Chris Nelder actually put together a number of my bad forecasts in 2009, although he somehow missed the 2008 pieces mentioned above.  The kind interpretation would be carelessness on his part, not cherry-picking, but I included his list in my book (chapter 9), since my intent is not victory over my critics, but understanding the market economics.

The 2008 collapse from the peak of $145 to a low of $34 was obviously not due to a phenomenal shift in market fundamentals.  U.S. crude oil inventories rose during the first months of the year as prices were soaring and were at roughly the same level when prices peaked at $147 in July 2008 as when prices bottomed out at year’s end below $35 (see figure).


Other factors are involved in analyzing the fundamentals, of course, but the market was clearly responding to what’s known as ‘trend trading,’ as investors ignore anything but the rising price trend.  People are buying oil because it’s going up, and it goes up because people are buying it, and you can make money as long as you get out before the ‘last fool.’ But with the collapse of the mortgage derivatives market and the slump in the broader stock market (see figure), the psychology of the oil market turned bearish and prices collapsed by two-thirds before recovering.


Could there be a similar market or asset collapse in the near future that would cause a contagion effect?  Three candidates seem most likely to be bubbles at present: Bitcoins, Tesla stock, and the broader U.S. stock market. All appear to be overpriced and have experienced significant growth in value, with Bitcoin the most prominent. The price has risen by from $800 in mid-December 2016 to near $20,000 now,  and the market capitalization has grown to approximately $300 billion. While blockchains are novel and complex, this type of price increase usually reflects irrational exuberance and trend trading.  Still, the market capitalization does not seem large enough that a collapse in value would affect the economy or other financial assets such as commodities.

Tesla Motors is a different animal altogether, a physical company with revenues of $7 billion in 2016,  and a market value of nearly $60 billion. Still, while the stock price grew rapidly in the first half of 2017, the one-year gain has been less than 100%, far below the rate for Bitcoin. Rather, the company’s stock price raises concerns because it provides a market capitalization for the company similar to other auto manufacturers like GM, which has more than twenty times the revenue of Tesla. Investors are buying in on the company’s potential, rather than its current operations, not uncommon for a startup but still relying on rosy assumptions which may prove to be unrealistic.

The stock market is probably the most important case, the 500-pound gorilla (not to be body-shaming).  The S&P 500 price to earnings ratio is now about 25, which is well above the historic norm of about 15.   Of course, the current tax reform bill and its potential to increase profits is priced into the market, but still, the potential for a 25-50% drop is very real.  And given that the market capitalization just for the S&P 500 is over $20 trillion, a bear market for the stock market would be far more meaningful as a source of contagion on broader markets.

Given that the economic expansion is growing long in the tooth, the potential for a slow-down or recession in the next year is very real, and could see a significant retreat in stock market prices and a sell-off in other assets, from gold to oil.  Since economic weakness translates directly into weakness in oil demand, lower oil prices after a stock market retreat followed by a recession appear highly likely.  This is reinforced by the fact that oil supply is not affected by demand but prices, meaning the supply response will lag the demand response, initially reinforcing downward pressure on prices.

Compliance With Output Reductions

Since 85% of the agreed production cutbacks (just under 1 mb/d) have been made by the big three (Iraq, Russia, and Saudi Arabia), leakage from the smaller countries is of only minor concern.  Instead, a conscious decision to reverse production cuts from one or all of those three would probably be necessary to crash prices.  (One large producer ending its cuts would almost certainly mean all three doing so; see below.)  As of now, adherence is quite good, especially in aggregate, as some, like Mexico, are more than achieving their targets.  (See Table.)


The main reason for the success of the most recent OPEC/non-OPEC producers’ agreement is that so many countries joined the effort and adherence to the reductions has been fairly high.  A portion of the reduction in oil supply has been incidental, most notably in Mexico, Venezuela, Kazakhstan and Angola, where production has dropped primarily for technical reasons.  However, the most important contributors—Iraq, Russia, and Saudi Arabia—have also shown a high degree of compliance, which has helped discourage others from cheating.

Still, many of the smaller members are not in compliance, and should the market weaken, attention could be focused on their failure to live up to the agreement and the larger players might see their resolve weaken.  The most important case is Kazakhstan, where production is expected to rise as Kashagan production progresses towards its phase 1 plateau.  That alone might not be enough to encourage the bigger players to renege, but could contribute to a change in perception amongst the other contributors, putting pressure on the remainder.

The weakest link in the chain is Iraq, which has dire revenue needs and is considered a particular threat by the Saudis because of their aggressive long-term expansion plans.  Other countries, like Iran and Venezuela, have minimal ability to expand production and are unlikely to have an impact on overall supply next year (except for continued Venezuelan declines).

At this point, it appears unlikely that non-compliance will be a factor, but as 2018 progresses, if compliance drops especially for Iraq or Russia, then it is possible that the Saudis will choose, as in 2014, to let the price decline.

Defense of Market Share

OPEC’s market share, loosely defined, remains an important indicator of production and pricing policy for the group members, especially the Gulf producers with their large reserve bases.  The IEA projection of non-OPEC production growing more than demand in 2018 implies some loss of market share, albeit a modest one.  Certainly, compared to 1985, the threat is minimal, but considering the events of 2014, when the threat was to future not current market share (from shale production), then the possibility of OPEC members such as Saudi Arabia deciding to allow the price to drop increases.


If the weaker demand for OPEC next year is heavily dominated by increased shale oil production in the U.S., the larger producers might see that as a longer term threat that needs to be addressed.  OPEC and the IEA each project U.S. oil production growing by over 1 mb/d in 2018, vs. EIA’s forecast of a 0.8 mb/d increase, which would represent the majority of the pressure on OPEC’s market share.  If this is interpreted by large producers as heralding a longer-term decline, that is, if shale operations are expected to continue expanding rapidly, then a decision to allow prices to slide becomes much more likely.


From this vantage point, it appears highly likely that markets next year will continue to tighten and prices remain close to $60/barrel for WTI, and perhaps slightly above. A number of factors could cause a price spike, but most probably producers would raise production to stabilize them. A price collapse could occur in response to a bearish U.S. stock market, especially presaging a recession; cheating by Iraq or Russia; or U.S. oil shale production appearing so robust as to threaten OPEC’s long-term market share.
