One thing that should give us cause for optimism for 2017 and beyond is oil. You know, the stuff the left-intelligentsia said we were supposed to have run out of by now – but which the Saudis recently reminded us that there’s more than we know what to do with.

Contrary to popular belief, low oil prices are not necessarily a good thing. Even when economic times are good, low oil prices are inflationary and can be the sign of bad things to come (e.g. the 1990s leading up to the Asian Economic Crisis). Alternatively, as we’ve recently found out, low oil prices can also be a symptom of tough economic times due to low demand and activity in key economies in Europe and the USA. Indeed, you don’t see many people cheering the super low petrol prices we’ve seen recently. After all, there’s little use in having plenty of cheap fuel to put in your car if you’ve got nowhere to go.

In my previous job, I was general counsel for a company heavily involved in the oil game (among various other things). The oil game is a funny one by modern-Western standards. This is because it runs mainly on free market principles – for better or worse. Under our system, any time someone takes advantage of a free market, the typical outcome is for governments to intervene, change laws and distort the market. This is usually done in a misguided attempt to ‘make everyone happy’ (except the ‘greedy’ capitalist and those employed by them). In the global game of geopolitical musical chairs, this simply doesn’t apply to the world’s limited oil producing countries, particularly the ones that get to sit on the UN’s human rights committee.

Hence, the oil market is much freer than anything we’re used to seeing under our ‘capitalism supporting socialism’ style systems – and subject to a lot more volatility.

A brief history of oil prices

The limited countries that produce and supply the world’s oil often band together and play voodoo with supply in order to manipulate price… and other things. As a result, the world’s oil price has done things like this over the years:

The major spikes you can see during the 1970s/early 1980s and mid-2000s can be (very) briefly explained via the following graph:

In a nutshell, the price of oil began doing funny things following the 1973 Yom Kippur War. History records the Yom Kippur War as the occasion where the Egyptian/Syrian coalition significantly improved on its previous effort of lasting six days in a fight with Israel (in the aptly named Six-day War of 1967) – this time lasting almost 20 days.

When the Arabs realised the degree to which Israel had been assisted by the US (and that the Western World relied heavily on oil), the 1973 Arab Oil Embargo and 1973 oil crisis ensued.

Having had a taste of the fruits of market manipulation, the Arabs thought it would be a great idea to keep fiddling around with oil supply in order to maximise their gains. Naturally, it couldn’t be sustained. By the time the mid 1980s came along, the Saudis (*) saw the writing on the wall and abandoned their role as swing producer. Prices then continued to crash back towards trend in accordance with supply and demand principles.

Very interestingly, it was during this time that fracking (first tried during the 1940s) and shale exploration began growing some serious legs:

In the gas industry, an exploration area tends to be described as a “play.” In 1981, George Mitchell, one of the most powerful natural-gas barons in Texas, began to look for a play in an unlikely place: the Barnett Shale, a thick layer of rock, thousands of square miles in area, located deep under the land around Fort Worth. For years, oil and gas companies had succeeded in bringing up fuel from above and below the shale. Mitchell decided to drill into the shale and fracture it with highly pressurized fluids, freeing natural gas to be drawn to the surface. “We had people who told us we were nuts,” Dan Steward, a geologist who helped manage the Barnett project, recalls. “But for George Mitchell” — whose North Texas wells were drying up — “this was survival, this was need.”

Mitchell did not invent hydraulic fracturing, or fracking; it was first tried in the late 1940s and helped along by Department of Energy research in the 1970s. Before Mitchell, however, fracking had not been used commercially to free natural gas from shale. During the 1980s and early 1990s, Mitchell Energy drilled well after well, many of whose sites were determined personally by Mitchell, an expert geologist who dropped by his company’s engineering department daily to check for good news.

[TMR: none of this could have happened without oil being at such obscene prices – have another look at the above graph].

Now who would have thought that the abuse of market power would lead to consumers trying alternatives?

You go back, Jack, do it again

To people of moderate intelligence, the 1970s oil crisis confirmed that:

You. Cannot. Beat. The. Market.

To communists, socialists and other garden variety totalitarians, this fact has either:

• not been absorbed;

• been stored somewhere within the Bermuda Triangle of their brains; or

• been treated as an invitation to ‘have a go’.

Hugo Chavez made this abundantly clear when he incredibly tried to repeat the same oil supply trick in 2005:

Chavez also played a leading role within OPEC to reinvigorate that organisation and obtain members’ adherence to lower production quotas designed to drive up the oil price. Venezuelan oil minister Alí Rodríguez Araque‘s announcement in 1999 that his country would respect OPEC production quotas marked “a historic turnaround from the nation’s traditional pro-US oil policy.”

While oil prices sky-rocketed for a few years, it was fittingly only a matter of time before the market won again and the Saudis saw the writing on the wall:

In the last quarter of 2014, in the face of possible oversupply, Saudi Arabia abandoned its traditional role as the global oil market’s swing producer and therefore it role as unofficial guarantor of existing ($100+ per barrel) prices.

In October, Saudi sources first prepared the market with statements that the country would be comfortable with oil prices as low as $80 per barrel for “a year or two.”

Aside from the fact that the market was winning yet again, the Saudis were concerned that the high price of oil was making US shale exploration economically viable and a major competitive threat. That is, the very same types of businesses that the Saudis helped put in business in the first place during the 1970s and 1980s (Saudi Arabia, meet irony).

However, rather than letting usual supply and demand principles dictate price, the Saudis decided to play a different game by:

• doubling down;

• flipping the switch in the opposite direction;

• flooding the market with oil; and

• driving price down to unsustainably low levels.

The Saudis were more than happy to take the hit to their bottom line for a year or two as long as it drove US shale explorers and producers out of business.

Helping things along for the Saudis was the fact that the economies of Europe and the US were still languishing under Obama and EU socialist inspired policies (many of which discouraged shale exploration and which encouraged more expensive ‘renewable’ energy). The combined lower activity from these economies helped keep the oil price low – and the US shale explorers whistling Dixie for any support under Obama.

All going to plan, shale producers would be out of business within a year or two and the Saudis would be free to keep beating the market.

As far as Australia was concerned, it was a disaster with project after project after project being scrapped and countless jobs lost.

Man’s best laid plans

The big problem for the Saudis was that the price of oil went well below what they had anticipated – crashing to as low as $26.55 in January 2016 (West Texas Crude). If $80 a barrel was the Saudi’s comfort point, then what was this?

To those who understand that markets cannot be beaten, there was only ever going to be so long that the Saudis could keep going this way. As it turns out, the election of Donald Trump appears to be the final straw which will end the Saudi’s two year game – with the following announcement coming barely a month after the US election:

Saudi Arabia has told its US and European customers it will reduce oil deliveries from January, as Russia says it is confident non-OPEC producers will fully join OPEC’s output limits in the first such move since 2001.

Suffice to say, Trump is about the last person on Earth who’ll stand in the way of US shale exploration – and the Saudis know it. Consequently, the price of oil is starting to return to trend:

Oil prices rose on Thursday after Saudi Arabia started talks with customers about a reduction in crude sales to support a plan by OPEC to lower global supply.

The Organization of the Petroleum Exporting Countries promised in November to cut output to help prop up prices.

Under the deal, Saudi Arabia agreed to cut output by 486,000 barrels per day (bpd), or 4.61 percent of its October output of 10.544 million bpd.

Investors have been suspicious that OPEC may not cut as much as promised, but several sources told Reuters on Thursday the world’s biggest oil exporter intended to lower exports to comply with the OPEC reductions.

‘There remains a question mark over whether OPEC, with a long history of non-compliance, will actually follow through (with the cuts). Very few respondents expect full compliance,’ Singapore Exchange (SGX) said, citing results from a survey of its participants.

If this can be sustained, then more of Australia’s onshore, offshore and shale oil and gas exploration will become viable again – which means economic activity and jobs. However, more importantly, more economic activity in the US means more Americans buying Matchbox cars (and other less important things) made in China using Australian iron-ore and coal. The early signs look positive:

Isn’t it interesting how the media only seems to be interested in arbitrarily foreshadowing a world of doom under Trump,  when the simplest of economic dots are staring them in the face?

 

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(*) To understand why the Saudis play such an influential role when it comes to the world’s oil (and why OPEC comes and goes at its whim), you need only look at the following production and cost graphics: