1970s Oil Crisis Redux or Oil Price Rout?

It has been four weeks since a major military attack on critical oil facilities in Saudi Arabia shocked the world and very little has happened to suggest such an event couldn’t happen again. That begs the question: Why are oil prices falling?

If you are a politician sitting in Washington D.C., it could be tempting to explain the calm as stemming from the changed crude oil supply situation of the United States where rising crude oil production – now exceeding 12 million barrels a day – has allowed the United States to become a major crude oil exporter. Citigroup is projecting that the startup of a new Texas oil pipeline will allow U.S. crude oil exports to expand into 2020, up from the 3 million b/d recorded over the summer. That’s created the impression that rising U.S. oil production can replace any disruption from the Middle East. Unfortunately, the numbers don’t actually suggest that.

Before the United States takes an energy independence victory lap, it could be wise to consider that America’s crude oil import balance isn’t all that different than it was ahead of the 1973 oil crisis. Yes, that’s right. You did not misunderstand me. I am saying we relied on the same percentage of crude oil imports in 1972 as we do today.

In 1973, the United States was a crude oil importer. In 2019, the United States is a crude oil importer. The United States still has to worry about a major disruption in global oil supply. Here are the numbers:

In 1972, the United States consumed an average of 16.4 million barrels a day (b/d) of oil. That same year, U.S. crude oil production was 11.2 million b/d and imports of foreign crude oil, to the tune of 5.2 million b/d represented 32 percent of U.S. consumption. By the fall of 1973, U.S. crude oil imports were about 6.2 million b/d.

In July 2019 (the latest month for official U.S. government statistics), U.S. crude oil production was 11.9 million b/d, an impressive rise since 2008 when U.S. crude oil production bottomed out at 5 million b/d. Oil consumption in July 2019 was 21.1 million b/d. The deficit of 9.2 million b/d of crude oil or 43 percent of U.S. consumption is complex. That’s because U.S. shale production includes an additional 4.8 million barrels a day of natural gas liquids, some of which can be used in U.S. oil refineries. Ultimately, the United States imported about 7 million b/d of crude oil from other countries in July 2019. We exported 2.9 million b/d of U.S. light sweet crude oil from tight oil plays in Texas, Oklahoma, and other states for net crude imports of 4.2 million b/d. The net import number is about 20 percent of U.S. oil consumption, better than the 32 percent in 1973, but not enough to matter. The 7 million barrels a day of physical crude oil imports from abroad, which includes oil from Mexico and Canada, is 33 percent, roughly the same level as in 1973. The United States is, however, also a large exporter of refined products. Presumably, in an extreme war situation, the United States could limit those exports to prevent physical shortages in the United States.

Saudi Arabian oil production represents about 10 percent of global oil supply. If it were substantially knocked out by a second or third military attack, it would be hard for U.S. oil producers to replace that amount of oil in a short period of time.

Saudi Arabia was exporting 7.4 million b/d of crude oil prior to September 14 when a combination of cruise missiles and attack drones damaged major crude oil processing plants at Abqaiq and important facilities at the large 1.5 million b/d Khurais oil field. Expedited repairs and redundant equipment and facilities have allowed Saudi Arabia to restore export levels quickly, but a second attack would be harder to bounce back from. Spare oil production capacity is constrained and inventories are being drawn down. Moreover, other regional oil facilities in Southern Iraq, in the United Arab Emirates and in Kuwait could be vulnerable to similar attacks.

By comparison, U.S. oil production grew close to 2 million b/d in 2018 and that was an amazing technical accomplishment, but it is less likely that U.S. producers could increase output by three, four, or five million b/d in short order to replace lost Saudi or Iraqi barrels. It would likely take the United States several years to achieve this larger level of increase.

While U.S. tight oil production from shale could be expected to increase in three to six months following a major rise in oil prices, bottlenecks could hinder a fast response. Hiring additional work crews, purchasing drilling equipment, and other logistical obstacles could slow down the U.S. industry response initially. The time lag could leave markets more vulnerable to any major disruption of oil from the Middle East that lasts longer than a month or two. U.S. shale production grew less than 1 percent in early 2019 as operational issues plagued firms such as Concho Resources, which suffered a production setback when the company found it was placing its wells too close together. Stock values of some smaller U.S. independent oil producers have taken a beating this year, and some speculators are positioning themselves in credit swaps markets to benefit from any fall in oil prices that could worsen U.S. shale producers’ performance. Institutional investors and their hedge fund managers have seen volatile returns since 2014 when holdings in shale companies turned suddenly negative from the collapse in oil prices. As a result, easy capital to expand drilling programs in the event of an oil price rise could be harder to come by this time around. Giant U.S. independent oil producer ConocoPhillips just announced it was raising its dividend by 38 percent and buying back 5 percent of its shares in an effort to please investors.

All of this should mean that oil prices should be carrying a war premium. Instead, prices are falling.

Cornerstone Macro suggests in a recent note that it is possible that oil markets have “deduced from all this that the odds of a negotiated way out of strife and sanctions, and an imminent return of Iran’s supply to market” is built into oil price expectations. The macro analysts say they are “less sanguine” about that outcome. It does seem optimistic under the circumstances of escalating attacks on regional oil facilities since January 2018. Europe, Japan, and most recently Pakistan, have actively tried to defuse the conflict between Iran and Saudi Arabia. But even if a ceasefire does seem to take hold in Yemen, for example, the military leverage Iran has over major installations of its neighbors would not be alleviated unless the region saw some substantial movement towards demilitarization of weapons systems. That seems unlikely given the number of active conflicts and internal protests across the Middle East.

Another explanation for falling oil prices are fears that oil demand will sink significantly in 2020 as recession grips major economies. Oil demand in the industrialized economies fell by 400,000 b/d in the first half of 2019, compared to a year earlier, including a 200,000 b/d drop compared to last year for Europe’s big five economies – Germany, France, UK, Italy and Spain. Sentiment is that continuation of the U.S.-China trade war will start to take its toll on Asian oil demand as well, though Asian oil demand is expected to average 28 million b/d this year, up from 27.1 million b/d in 2018. Global oil demand is running about 1 million b/d higher this year than 2018 levels.

There could also be a simpler, structural explanation for languishing oil prices. There are fewer speculators willing to bet the price of oil up. Many of the heady oil traders known for making big bets have retired in recent years.  Also hedging by oil companies in which shale firms sell their production forward to lock in oil prices as they were rising this fall has effectively kept a lid on the market. The combination of these two market features has lessened the momentum to speculative bubbles in oil. Long-term investors also worry that oil demand will peak eventually as new oil saving technologies take hold and governments act to limit greenhouse gas emissions, and this has reduced interest in long-short commodity funds.

Still, on September 14 when Saudi Arabia’s oil facilities were attacked, U.S. oil prices went up 15 percent in one day. Traders who were betting the price of oil would continue to go down had to adjust their bets and that created a large price increase. The problem with Iran has not, in fact, been resolved and markets could see a similar black swan event. Any global event will affect U.S. markets, regardless of how much oil we have at home.

Oil is a global commodity and its pricing is determined by global supply and demand. Since the United States is part of the global market and imports crude oil from abroad, U.S. crude oil prices are influenced by global pricing trends. The easiest way to explain this phenomenon is to consider water in a swimming pool. If someone comes with a giant bucket and takes water out of the shallow end of the pool, the water level goes down not just in the shallow end of the pool but for the entire pool equally. By the same token, if more water is put in the pool by a water hose, the water level goes up throughout the pool and not just on the side where the hose pours in. The oil market is the same. If the oil market loses Saudi or Iranian or Iraqi oil, all oil commodity prices are affected for all users of oil, not just users of the disrupted oil.

Washington pundits could be advised to keep that in mind as they consider how the United States will prepare for the volatile situation across the Middle East. 1973 could seem like a long time ago and U.S. production could be rebounding, but it is not the case that the U.S. no longer has to “care.” There are 276 million vehicles on the road in the United States of which 99 percent run on oil. We should change that, but so far, we are not moving quickly in that direction. Just saying…