Research Spotlight: Demystifying the oil market

Oil pump at sunset-stock photoIn summer and spring of 2008, prognosticators said oil prices would rise to $200 or more a barrel, and forecasts for $300 oil still linger. But forecasters hold little sway over the real price of oil, current or future. Unlike the stock market – which moves according to incident, expectations, confidence and occasional mania – oil markets move on the more tangible fundamentals of the real asset.

James L. Smith, Cary M. Maguire Professor of Oil and Gas Management in SMU’s Cox School of Business, shows in his research that the oil price spikes of summer 2008 will not necessarily be the trend in the future. Based on supply and demand factors – an analysis of which is missing in many of the high-end forecasts – Smith reveals the causes behind the much-debated high trajectory of oil prices and how the OPEC cartel had a lot to do with it. In “World Oil: Market or Mayhem?,” published in the August 2009 Journal of Economic Perspectives, Smith offered a view of things to come based on history and fundamentals.

Global demand for crude oil has increased by 80 percent overall since 1975, whereas actual OPEC production and non-OPEC supply have each grown by just 24 percent. During the 1980s, while global demand for oil was shrinking, the supply of non-OPEC oil was expanding robustly, putting substantial downward pressure on price. OPEC producers responded by cutting output nearly in half between 1979 and 1985. After the steep decline of the 1980s, OPEC production was not fully restored until 2004.

“OPEC’s production restraint represents a commercial choice, not a geological ultimatum or a reflection of high marginal costs,” Smith says.

From the period 2004 to 2008, global demand increased by 33 percent, while non-OPEC supply decreased by 23 percent. Although OPEC members responded by increasing their production, they lacked sufficient capacity (after years of restrained oil field investments) to bridge the growing gap between global demand and non-OPEC supply. Prior research by Smith revealed that OPEC’s goal is to set the price, and members synchronize production levels in pursuit of that goal.

Consumers have suffered from OPEC’s failure as well as its success: Failure to manage installed capacity has increased price volatility, while success in restricting capacity growth has driven up the average price level. OPEC’s production capacity – 34 million barrels per day – is virtually unchanged from 1973. Meanwhile, the volume of its proved reserves, deposits that could have been tapped to expand capacity, doubled over that span. In comparison, non-OPEC producers have expanded their production capacity by 69 percent since 1973.

During the second half of 2008, the collapse in demand for oil around the world was due to economic decline. Despite global consumption (and consequent depletion) of almost 700 billion barrels of crude oil during the past quarter-century, the stock of remaining proved reserves has doubled from 700 billion barrels in 1980 to an all-time high of 1,400 billion barrels.

“Consider the impact of horizontal drilling in oil and gas,” Smith says. “Huge resources that were previously uneconomic can now be developed because of that technological advance – an example being the Williston Basin, the largest undeveloped oil resource in the U.S.” He adds that advances in the processing of seismic data beneath the ocean floor revealed large oil deposits in the Gulf Of Mexico and Brazil, previously hidden beneath layers of salt.

“We peeled back another layer that we previously didn’t know how to penetrate,” he adds. “New technology can have a big impact on the resource base and price.”

Read more from the Cox School research blog