The Oil Industry’s Slippery Slope

The world was reminded of the importance of the oil trade late last year as Iran escalated international tensions by holding up tankers in the Strait of Hormuz. OPEC, our alliance with Saudi Arabia, domestic shale production, national security: all of these are reminders of the predominant role oil plays in geopolitics.

With all that, you’d think it’d be valuable. But if economic comparisons between bottles of water and diamond rings have taught us anything, it’s that goods aren’t priced by “objective utility” but by supply and demand. The price of oil has been dropping fast.

The market is being attacked from both sides. The current pandemic has dropped demand by at least 20%, while OPEC is engaged in a price war with Russia that dropped prices 30% before COVID even hit [1]. The resulting year-to-date price drop has been over 55%.

Oil firms are interesting economically as well. The industry is generally heavy in capital expenditure--money spent to maintain equipment. While the fixed costs of creating and maintaining an oil well are high, the marginal costs other than labor are near zero.

Because the majority of oil supply is controlled by OPEC, they have had no problem artificially limiting supply to bring in more oil revenue. Recently Russia started a price war with the OPEC cartel. Both groups are free to ramp up their oil production with relatively little shift in costs, allowing for the massive drop in price. The resulting current global surplus is literally unprecedented[2].

The drop in price has priced out many producers of oil in areas where marginal costs are higher. For example, US-based shale production, operated on thin margins even when oil prices were high. But due to high capital expenditure in the industry, oil production has a large area between ATC and AVC. Firms will gladly operate at a loss to keep their equipment operating and paid for, hoping for a recovery in prices. Even then, many US firms are shutting down[2].

One more interesting tidbit: oil has a relatively high “cost of carry”--it costs a lot to store massive amounts of it. Because there’s limited global storage space, and oil prices are expected to generally increase, firms pay above market price for “futures” or promise of future delivery. However, as global storage begins to dwindle, it’s possible the “spot” (current) price of oil could go to zero or below (!), while future oil remains above water[3][4].

Lastly, it’s important to acknowledge that the supply of oil is largely dictated by politics. The economic stability of many countries depend on exporting it, America’s national security depends on creating enough domestically, Russia doesn’t like the US oil industry developing, and China imports an absolute ton of it. For that reason, economic factors can change in an instant. Hours before I began writing, oil jumped over 30% after Trump announced the expected end of the OPEC-Russia price war.[5]


[1] https://www.forbes.com/sites/feliciajackson/2020/03/31/could-covid-19-drive-a-structural-shift-in-the-oil-markets/#4c74048a582f
[2] https://www.cnbc.com/2020/03/17/oil-prices-could-hit-the-teens-in-coming-weeks-as-markets-crater-over-coronavirus-and-price-war.html
[3] https://www.cnn.com/2020/04/01/business/oil-prices-crash-storage-space/index.html
[4] https://www.forbes.com/sites/gauravsharma/2020/03/29/oil-futures-in-record-contango-of-over-10-for-first-time-since-2009/#5d340b2e32fd
[5] https://markets.businessinsider.com/commodities/news/oil-prices-jump-trump-comments-on-saudi-arabia-russia-deal-2020-4-1029057828