Petro-Logic: Understanding an Inscrutable Commodity

When the oil price cycle and the political cycle are out of whack, we’re doomed to be caught flat-footed

The essentials

The laws of the oil market seem to have come undone. Prices have dropped precipitously yet cheaper oil is not translating into economic growth and producers are still pumping their wells. Perplexed? The fundamentals of the oil price cycle haven’t changed, says David Detomasi of Smith School of Business. What’s changed are the compression and amplitude of the cycle. In this conversation with Smith Business Insight, Detomasi discusses the logic of oil prices and the challenge of making sound public policy for a commodity that clearly drives us to distraction.  

The Oil Price Cycle is Alive and Well

The price of oil does follow a cycle and historically speaking that cycle runs between seven and 10 years for its full completion. It was in place from the very moment the oil business began, when Colonel Drake drilled a hole in the ground in Titusville, Pennsylvania, and in short order a thousand derricks went up all around his site. But none of these producers thought that if they were all successful at getting at this stuff, they’d have a flood of oil hitting the market and drive the price through the floor, bankrupting everyone. The whole idea behind what came to be known as Standard Oil was to control the amount of supply hitting the market by monopolizing oil production in the U.S., thereby stabilizing prices, investment, and profit. A hundred years later, that was OPEC’s plan.

Jumping ahead to today, the people who really have to pay attention to oil price cycles are the private sector oil producers. Canadian oil producers are price takers: they can only react to what market signals are telling them. And in a seven- to 10-year cycle, at the low end of the cycle there is underinvestment because it’s difficult to know when to pull the trigger on new investment. Typically there’s a lag between a price increase and the amount of money people are spending on exploration because they want to make sure growth is for real.

Once you start committing capital, it takes between five to seven years to go on stream. That’s what we’ve seen recently as a massive amount of investment made seven, eight years ago — fracking and nonconventional oil supplies, oil sands, offshore — all became available. OPEC is looking at this and saying, ‘Now we have a massive amount of new supply that we don’t directly control. The only way we’re going to protect our market share is by engineering a price drop.’ And the Saudis decide to keep the taps open.

What’s new is the compression of cycle time and amplitude of the price swings

This is nothing new. What’s new is the compression of cycle time and amplitude of the price swings. Historically, oil price drops were maybe 20 or 30 percent and prices took a longer time to deflate. Today’s drop has been 70 percent and occurred in less than two years.

The amplitude is much higher. That’s because you have many new players in the game — Iran and Iraq, whose production levels have been very low compared to what they could be, Russia, and non-OPEC suppliers like Canada and others ramping up, so there’s a lot more oil coming on the market.

You also have the amplifying effect of financial markets. Money can flow in very quickly and money can be taken out very quickly in oil and oil-derived products in trading activity.

So I believe in the cycle but I believe its amplitude is bigger and it appears to be able to happen faster. It’s no longer a nice smooth ride.

Oil Is in a League of its Own

I don’t know of another commodity that has the same combination of absolute necessity for a modern functioning economy, non-substitutability in the short term, hard to get at but also highly concentrated in geopolitical places, and with clear financial implications for people, for governments, and investment banks. There’s nothing that is as immediately impactful as oil. That’s why we pay so much attention to it.

But because of that, we overplay it too. Five or seven years ago, people worried about oil supply shortages, but you don’t see anyone worrying about it today. The fields are still being drained at the same rate. The price of oil today really has nothing to do with how much is available. It rarely reflects what’s happening right now. It has much more to do with how much has been invested and where and a host of other factors. The fundamentals are really separate from the headlines.

Why We’re Stuck in the Cycle

There are many classical reasons around why we’re still caught in this cycle. One is that the politicians can’t break out of it. There’s plenty we could do but they’re politically challenging. I was a huge fan of (former Alberta Premier) Peter Lougheed, who created the Alberta Heritage Savings Trust Fund in 1976. He said, We’re going to take the money we’re making right now and we’re going to save it instead of spending it. If we had kept up what Lougheed had envisioned, Alberta might have had hundreds of billions of dollars in a trust fund. Instead it’s now under $20 billion. The political temptation to distribute oil revenues primarily as a vote-getting measure proved impossible to resist.

Number two is that renewables always seems to have a tough time gaining traction. I have yet to see how non-oil renewables, although they have been growing, can quickly replace the trillions of dollars of entrenched infrastructure we have to support carbon-based energy. And even if they could, they couldn’t do it overnight. The wholesale, rapid conversion from carbon to non-carbon while maintaining adequate economic growth? Putting a man on the moon would be easy compared to that.

Pipelines and Politics

The political cycle and the economic cycle are not the same. In 2006, Stephen Harper went to the UK Chamber of Commerce and made that speech about Canada being an energy superpower. He said, We’re going to do whatever it takes to fashion Canada’s infrastructure in such a way that it can become that because we’re a good country with sound regulation.

Economically speaking, that probably ought to have been the time when he said, Okay, we’re going to tax some of this stuff and we’re going to invest in renewables and become more innovative in our manufacturing sector, because we should be doing counter-cyclical stuff. But he didn’t do that.

Our new prime minister seems to be trying to do both. He wants to talk about Canada as a technology place but he also is trying to get this (Energy East) pipeline built. Trudeau has a little bit of freedom because he’s not going to get elected based on what he does or doesn’t do in the energy sector.

An enlightened national policy would have diversity of supply and diversity of demand as a priority

Consumers need to worry about diversity of supply: if one supply source gets cut off, you need to have another one that can fill in. And those who sell oil have to worry about diversity of demand. For far too long, Canada has been content to just sit back and assume that the Americans would buy everything we could ship them, because they did. Now with oil fracking, the export market isn’t so secure.

An enlightened national policy would have diversity of supply and diversity of demand as a priority, keeping as much of the revenue in Canada as we can. A courageous political decision would be to build refinery capacity with tax dollars now as an infrastructure project. You need to have some government involvement to help shoulder the risk of a multibillion dollar investment. At low times is when governments should take the investment lead, and at the high times they should get paid back with more royalties. But it’s tough to do electorally: people’s memories are a bit too short.

Interview by Alan Morantz

Smith School of Business
Goodes Hall, Queen's University
Kingston, Ontario
Canada K7L 3N6

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