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The oil crash explained: John Kemp on the 5 causes that led to oil’s decline

John Kemp
John Kemp
Senior Market Analyst, Commodities and Energy, Reuters

With oil prices continuing to plummet, John Kemp, Senior Market Analyst, investigates the series of events that led to the oil crash and examines what the future has in store.

  1. In 2005, spooked by a rise in oil prices to $55 per barrel, from less than $20 at the end of the 20th century, U.S. legislators approved the Energy Policy Act.
  2. In 2020, due to the global coronavirus pandemic and COVID-19 lockdowns, a negative oil price of US$37.63/bbl for May’s West Texas Intermediate contract came with storage tanks in the United States filling fast and running out of capacity.
  3. The U.S. government has shown no signs of changing its policy of not imposing mandatory production cuts on its oil producers, expecting natural attrition to reduce output throughout 2020.

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On June 22 last year, two tankers loaded 1.3 million barrels of crude at the port of Tobruk in eastern Libya. It was an event that signaled the end of a decade-long boom in oil markets.

Just three days earlier, benchmark Brent peaked at almost $116 per barrel, the highest level for 2014, before beginning a relentless slide that would see prices sink by more than 60 percent over the next seven months.

The reopening of Libya’s ports and oilfields, which had been closed for months by unrest, marked the oil market’s tipping point. Libya’s production, which had dropped to 250,000 barrels per day (bpd) in April, May and June from around 1.8 million bpd before the country’s civil war in 2011, rebounded to almost 900,000 bpd over the next three months.

The increase was significant, but not because of the volume. World production and consumption of oil are around 93 million bpd so the extra 600,000 bpd amounted to less than 1 percent of daily demand. The resumption of Libyan exports mattered because it was so unexpected.

By the beginning of September, fund managers had slashed their net position in Brent- and WTI-linked derivatives by 60 percent, the equivalent of more than 400 million barrels. Amid this massive liquidation of positions, Brent fell more than $13 per barrel, or 11 percent, to the lowest level seen in over a year.


Source: A Brief History of the Oil Crash

Much more was to come. Brent dropped to $86 per barrel at the end of October, $70 by the end of November, $57 by the end of December and less than $47 on Jan. 13, 2015.

The price drop plunged the industry into crisis, with major international oil companies and small independents cancelling billions of dollars worth of projects planned for 2015 and 2016.

5 defining factors that plunged the industry into chaos:

1.       An inevitable decline

If the resumption of Libyan oil exports served as the immediate trigger for the price plunge, the seeds were sown years earlier at the height of the boom.

In 2005, spooked by a rise in oil prices to $55 per barrel, from less than $20 at the end of the 20th century, U.S. legislators approved the Energy Policy Act. The legislation, which passed with substantial support from both Republicans and Democrats, instructed fuel distributors to begin blending increasing amounts of ethanol into the gasoline supply.

In 2007, responding to a further increase in oil prices to around $70, Congress passed the Energy Independence and Security Act, which stiffened the blending targets even further and raised fuel-economy standards for vehicles sold in the United States.

Those acts formed part of a raft of laws and government regulations introduced in the United States and other advanced economies between 2004 and 2014 to promote energy conservation and reduce demand for increasingly expensive imported oil.

In retrospect, 2005 proved to be the peak year for oil consumption in the United States and other advanced economies.

Source: Reuters: Shannon Stapleton

U.S. consumption of motor gasoline, diesel, jet fuel and other refined products declined by more than 2 million barrels per day, almost 12 percent, between 2005 and 2013, even though the country’s population increased by more than 20 million over the same period and real economic output grew by 10 percent.

It was the biggest drop in fuel demand in history and mirrored around the industrialized world. On one estimate, the advanced economies’ fuel consumption in 2013 was 8 million bpd below what would have been predicted had the pre-2005 trend continued.

2.      The birth of the shale revolution

High prices did more than just restrain demand. They were the key catalyst for the U.S. shale boom, which resulted in the fastest growth in oil production in history during 2013 and 2014.

A quadrupling of oil prices between 2002 and 2012 – coupled with significant technological improvements in steering equipment down wells and taking measurements remotely – created conditions for the shale revolution.

The result has been an extraordinary renaissance in U.S. oil production. Output surged from 5 million bpd in 2008 to an average of more than 8.5 million bpd in 2014, and stood above 9 million bpd at the start of 2015.


Source: A Brief History of the Oil Crash

Production growth has been accelerating as shale drillers become more efficient at locating wells and drilling them faster. Output increased by 160,000 bpd in 2011, 850,000 bpd in 2012, 950,000 bpd in 2013 and 1.2 million bpd in 2014, according to the U.S. Energy Information Administration.


Source: A Brief History of the Oil Crash

So much extra crude has come from shale and other sources that oil prices continued to fall throughout the last three months of 2014 and into the first weeks of 2015 – even as Libyan supplies experienced new interruptions.

3.      The market is oversupplied

By 2012 or 2013 at the latest, the global oil market was on an unsustainable trajectory with stagnating fuel demand meeting rapidly increasing supply.

The only solution was a sharp fall in prices, which had been above $100 per barrel, to curb demand destruction and reduce investment in new sources of production.

But the need for lower prices was masked by two factors. First, many observers doubted the shale revolution could last. Second, increased output from North America was offset almost exactly by a loss of production across the Middle East and Africa as a result of war, unrest and sanctions in Libya, Syria, South Sudan and Iran.

By 2013, however, that position was no longer tenable as shale production continued to accelerate. OPEC’s 2012 World Oil Outlook acknowledged “shale oil represents a large change to the supply picture” and the scale of that shift has become more obvious over the last two years.


Source: A Brief History of the Oil Crash

With so much new crude coming from U.S. shale, the preservation of balance in the oil market required ever-increasing supply disruptions from conventional producers in the Middle East, North Africa and other parts of the world, as well as continued demand growth from China, Southeast Asia and the Middle East.

Growing turmoil in the wake of the Arab revolutions that started in 2011 had almost eliminated Libyan oil exports and uncertainty in Iraq continued to cause concern. But from late June, it became increasingly clear that geopolitics would not further interrupt the supply of crude. Oil continued to flow from all parts of Iraq and increase from Libya.

Robbed of the last remaining source of support, the incipient oversupply in the market became increasingly obvious and a sharp price correction was inevitable.

4.      The price war begins

Senior policymakers in Saudi Arabia appear to have grasped the inevitability of lower prices faster than many investors. Throughout September, October and November 2014, speculation intensified about possible production cuts by OPEC members, led by Saudi Arabia.

Cutting production to keep prices artificially high would only sacrifice Saudi Arabia’s and OPEC’s market share and allow shale production to continue expanding. Instead, the kingdom determined to let prices decline enough to begin curbing investment in new shale wells and formations.

In the end, the kingdom suffered a double hit to its revenues from lower prices and reduced output. Saudi policymakers today are determined not to make the same mistake.

On Nov. 27, 2014, OPEC announced that it would maintain its combined production at 30 million bpd. Brent, which had already fallen to $77 per barrel by the time of the OPEC meeting, dropped another quarter to $59 over the next month as the market digested the fact that the group would not come to the rescue.

5.      A painful adjustment for the industry

Oil prices must ultimately drop to a point at which the market rebalances – which means eliminating some of the previously forecast production growth and slowing or reversing the loss of demand.

In the shale patch, producers slashed drilling programs for 2015 and started to idle rigs, conducting layoffs. Between early October 2014 and Jan. 9, 2015, almost 190 rigs previously drilling for oil in the United States were idled – around 12 percent of the total. In all, 550 rigs could be deactivated in the coming months.

Estimates of breakeven costs vary, but many sources suggest oil prices have fallen beneath the threshold needed to maintain current output levels.

What happens to production and prices in 2015 therefore largely depends on the responses of the shale companies – how far they cut drilling and production, how far they can improve efficiency and cut costs to reduce the breakeven price for new wells while sustaining production in an environment of lower prices.

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