The Final Word - Think like an Austrian (Oil & Gas Financial Journal)
Excerpted from Oil & Gas Financial Journal
By Cliff Atherton, Managing Director
HOW CAN WE EXPLAIN the dramatic price moves transpiring in the oil market over the last 12 to 18 months? If you were trained in the economics of static equilibrium (neoclassical economics), you could say that the market has been disturbed from its equilibrium by an exogenous shock, pushing prices down until market forces eventually establish a new equilibrium.
Imagine a marble spinning along the inside walls of a bowl. Participants don’t know exactly how many revolutions will be required or how deep the bowl is, but ultimately the marble will come to rest at the bottom of the bowl, a new equilibrium price that balances supply with demand. If you are an econometrician, you could grind away on data sets in an attempt to forecast the new equilibrium price.
Austrian economists take a slightly different approach to the questions they ask and the assumptions they make about market participants. Most Austrians follow the lines of argument and analysis developed by the Austrian School, which is most closely associated with Mises, Hayek, Kirzner, and their students. Austrians focus on the market adjustment process rather than static equilibrium, on adjustments that individuals and firms make in response to constantly changing market circumstances.
Firms and individuals in the market make plans and implement decisions in real time, despite the fact that they cannot know exactly what the future will bring (ignorance). Firms invest for the long-term; speculators invest for the short-term. There is no reason to expect their plans to match. The market process will reflect the degree of discoordination that ultimately results from the disparate plans implemented by market participants. The real world does not include the auctioneer who tidies things up in the neoclassical framework. The marble never really comes to rest because the market process is continuous.
The major technical change in the global oil market over the last five or so years resulted from the shale revolution in the US. This is no exogenous shock; it is an endogenous change resulting from entrepreneurial innovations in drilling (horizontal, directional drilling) and completion technology (hydraulic fracturing). Whether you call it creative destruction or alertness to opportunity and discovery, the result is the same. The efficiency of these new technologies dramatically altered the economics of development and the reserves recoverable from well-known formations. New plans involved much higher levels of investment and resulted in dramatically increased US production.
Development of reserves requires capital in large amounts. Since the financial crisis of 2008, the US economy has been awash in investment capital available at all-time low interest rates, much of which flowed to E&P companies, as well as service and midstream companies. The market must now correct the maladjustment of investment in the industry – jobs must be eliminated and the value of specialized assets will fall.
The current downward spiral in oil was initiated by a change in Saudi Arabian oil policy. Previously, the Saudis practiced market discipline, maintaining the price level by acting as the swing producer. No longer willing to constrain their output, the Saudis have now stated that they will maintain a position as a reliable supplier, implying that they will meet customer demand at prevailing prices. Obviously, there is a price at which they might limit output, but the market has not yet reached that level. From a planning perspective, the Saudis’ intention cannot be to permanently drive down the price of oil. Their additional output has come at a very high cost; their aggregate oil revenues have fallen dramatically.
Both government-owned oil companies (GOCs) and investorowned oil companies (IOCs) have seen their revenues diminish by more than half. Assuming they are not too heavily leveraged, IOCs have more flexibility to respond to lower prices by cutting capital and operating budgets quickly. Many GOCs face a different situation. Governments also make and implement plans.
Much of the gross margin earned by GOCs is committed to funding domestic and other government programs. From the government’s perspective, these programs provide domestic tranquility and stability; they are as much a cost to be recovered from oil sales as the costs of finding and development. While the Saudis are in the best position to endure the pain, they cannot view current oil prices as a permanent condition. The oil price in their long-term plans must be one that funds their domestic plans.
While oversupply is the cause of our immediate pain, we cannot ignore the other blade of the scissors: demand. Since 2008, the global recovery has been weak and slow, as predicted by those who have studied debt-driven financial crises. There are mounting concerns of a recession looming in 2016. However, increased per capita consumption in the developing world ultimately must push demand up faster than supply.
In the face of these very current events, there is one undeniable hockey-stick graph in economic history that cannot be ignored: the growth of wealth and productivity. The inflection point on this graph is the onset of the industrial revolution. Along with specialization, the division of labor, and the growth of knowledge, the industrial revolution was characterized by the harnessing of energy, from rivers to steam to internal combustion. Today, hydrocarbons are a major input to all final products.
As Eric Beinhocker says in The Origin of Wealth, energy is a necessary input to all wealth-creating activities. Global wealth creation will grow and with it the demand for energy. So, the market process continues. Sooner or later, the marble will defy gravity by spinning its way up the inside walls of an inverted bowl. Over-investment is followed by planned under-investment. Cliff Atherton (firstname.lastname@example.org) is a managing director at GulfStar Group in Houston.
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