Small oil

Covid-19 has led to a historic decrease in demand for oil. But price plunges and market volatility are nothing new

Alexander Kemp

Extreme oil price volatility is not a new phenomenon. In 1859 Colonel Drake drilled a well at Titusville, Pennsylvania, and made the first discovery in the USA. Within a few months the price rose to c.$20 per barrel (in money-of-the-day terms). Within another few months it fell to c.20 cents per barrel. While price increases attract much more public attention, historically there have been numerous examples of major price falls. Thus in 1973-1974 the quadrupling of prices received far more interest than the subsequent price collapse in the 1980s. Since 2014 volatility has been extreme and generally unpredictable.

The price of every commodity is determined by the factors of supply and demand. In the case of the oil market there are unique features of the supply and demand curve which can combine to produce volatility. There are few substitutes for oil. The demand for it in the short run is very price inelastic. The quantity demanded does not respond significantly to a price change. Similarly, in the short run the amount supplied does not respond significantly to a price change. Following the 1973-74 quadrupling of prices through the action of OPEC, the economist Milton Friedman stated that consumers should not worry unduly because within a few months the price would revert to what it was prior to the hike. This would follow because consumption would fall and production from sources other than OPEC would increase. But the price held up for some years because consumption did not decrease noticeably and production from non-OPEC sources was very slow to increase. By the 1980s, however, consumers in OECD countries did respond significantly to the price increases (including the further doubling in 1979-1980), and production from non-OPEC sources including the North Sea did increase substantially. Together, the higher long run price elasticities of supply and demand caused the price to fall from a peak of $40 in January 1981 to $10 in July 1986.

In the first half of 2014, the Brent price exceeded $100. By this time, production from the USA was increasing at a rapid rate due principally to the fast growth of the shale oil sector. Up to this time the policy of OPEC had been to restrict output to maintain the price. Thinking changed within the group, particularly in Saudi Arabia, the dominant producer. It was felt that if cuts were made, the main result would be increased market share for the USA which would be to the long-run detriment of OPEC. Agreement could not be reached among members. Quotas were abandoned and each member pursued its own policy. The result was a major price decline.

By the late part of 2016, thinking within Saudi Arabia changed again. Revenues were well below those required for budgetary purposes. A plan to introduce substantial production cuts by the cartel plus some collaborating producers, principally Russia, was proposed and introduced from January 2017. The plan was deemed by traders to be credible and the price increased substantially. Subsequently there was some volatility reflecting in particular the imposition of sanctions by the USA on Iranian exports and the availability, for a time, of waivers to some of them.

As the year 2020 has progressed it has become clear that Covid-19 is a major epidemic. The measures that have been taken by governments around the world have resulted in a major decrease in oil demand. During 2019 world oil demand reached a peak of 100 million barrels per day (mmb/d). There are many guesstimates of the extent to which demand will fall this year including some in the 20 per cent-40 per cent  range. No one can yet be sure. The inevitable result has been a fall in price. It is noteworthy that a substantial reduction in world demand for oil is a unique event. The only other occasion historically was in the Great Depression of the early 1930s.

The effect has been sufficiently strong to produce a major change in policy by OPEC and its collaborators, particularly Russia. An abortive attempt was made to reach an agreement to curtail production in mid-March. The immediate result was a statement that Saudi Arabia would increase its production very substantially and make sales at much reduced prices. The further price fall then led to renewed negotiations between Saudi Arabia and Russia, and in early April an agreement was reached. The key feature is that from 1st May production by the group needs to be cut by 9.7 mmb/d or nearly 10 per cent of peak world demand. The agreement also indicated production cuts extending for specified periods into 2021.

While this represented a major reduction, market traders have generally not been convinced that it is sufficient to bolster prices, at least in the near term. Their scepticism has been reflected in the further falls in the price. The most dramatic event occurred on April 21, when the price of West Texas Intermediate (WTI) fell to substantial negative values, very briefly below minus $30. It should be stressed that WTI prices reflect the balance of supply and demand inside the USA. The Brent price reflects the balance of supply and demand for the world market as a whole.

In the USA the problem has been exacerbated by the lack of storage facilities for ongoing production. Storage has become so full that producers have had to make payments to others to take away their output. To alleviate this problem the US Government has stated that it will make purchases and put the oil into the Strategic Petroleum Reserve.

In the short run, very low WTI oil prices may be expected to continue. Production of shale oil will decrease, perhaps significantly by 2021. This should alleviate the market position. But relatively low prices by historic standards will prevail until demand turns round.

The Brent price should certainly maintain positive values, but in the near term the extent of the world demand decrease will have a dominant influence. Traders will also be watching carefully the extent to which the production cuts promised from May 1 are fulfilled in practice. There are already reports that the Russian oil companies are unhappy about the need to make substantial cuts. The other near term influences are the extent to which cessation of production in existing fields is accelerated at the current low prices. Postponement of new field developments will also influence the price in the medium term. We can certainly expect a continuation of volatility depending on the revealing of relevant information which is currently the subject of so much uncertainty. 


This article is taken from the May/June 2020 issue of Standpoint. To subscribe to the print and digital editions, including a full digital archive, click here.

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