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As oil prices tank, where did OPEC go wrong?

An oil well is seen near DenverAn oil well is seen near Denver
An oil well near DenverPhotograph by Rick Wilking — Reuters

Editor’s note: In his new book, Market Madness: A Century of Oil Panics, Crises, and Crashes, Council on Foreign Relations Fellow and Citigroup Analyst Blake Clayton shows that over the last 100 years, many fell prey to fears that the world’s oil is dwindling and prices are doomed to rise. Below is an exclusive edited excerpt:

The oil price crash that brought 2014 to a close was itself a sort of benediction on Wall Street: It was the nail in the coffin to the so-called “peak oil” debate, in which many experts had argued that oil prices were bound to rise — perhaps forever — as the world’s choicest oil reserves ran dry. Such gloomy forecasts of dire shortage and endlessly spiking prices are as old as the market itself, but they have always proven wildly incorrect.

Today’s glut is only the latest reminder, as U.S. crude for April delivery closed at $59.73 a barrel on Friday after hitting peaks of more than $100 in recent years.In 1998, “Oil shocked” It was a fitting headline for an Economist article describing the state of the oil market. Shock was indeed what the market was experiencing. But this was hardly the type of shock that Americans who had lived through the chaotic leaps in oil prices during the 1970s were accustomed to. It was the opposite extreme: oil had fallen to radically low prices and was dipping lower by the week as the year came to a close. A barrel of West Texas Intermediate was selling for around $18 on New Year’s Day, 1998. Eleven months later, it had collapsed to just more than half that. A gallon of gasoline cost less than $1 a gallon in the United States. Oil had not been this cheap since the summer of 1986, after Saudi Arabia had decided it was tired of trying to maintain high prices amid a lack of support from its Organization of the Petroleum Exporting Countries(OPEC) brethren. Adjusted for inflation, the price of oil had fallen to a 25-year low.

A number of forces combined to push prices downward. The East Asian financial crisis was the primary culprit. Precipitated by a collapse of the Thai baht in the summer of 1997, the panic saw the region’s stock markets fall by as much as 60% and caused oil demand in that part of the world, a pillar of global demand, to pull back sharply. It also meant that demand for oil elsewhere grew more slowly than usual. Even as demand worldwide was wilting, oil continued to flow onto the market, unrestrained by OPEC. Iraqi oil had begun to surge onto the global market for the first time since the Gulf War, rising from just shy of 600 barrels per day in 1996 to nearly four times that amount two years later.

OPEC, caught flat-footed by the Asian crisis, was in disarray. In November 1997, just as oil prices were starting to sink, OPEC ministers had agreed at one of their regular meetings to raise their production quota by 2 million barrels per day. They did so on the mistaken belief that world consumption would continue to increase at the same rate in 1998 that it had between 1996 and 1997, during the heyday of the Asian economic miracle. Raising quotas was an easy way to bring them closer in line with actual production numbers, since many of the exporters were cheating, producing at their maximum capacity regardless of the rate OPEC allotted them. As best as the OPEC ministers could tell, the fundamentals of the market appeared to justify the move.

As it turned out, their timing could not have been worse.OPEC had begun to ramp up production precisely as demand was starting to fall. OPEC met several times in 1998 in a vain effort to establish production quotas severe yet realistic enough to stop prices from sliding. Some members of OPEC, most vociferously Venezuela, were loath to cut back their output, particularly frustrating Saudi Arabia, which viewed Caracas and others as stealing its rightful share of the market. Amid the squabbling, prices slipped to $10 per barrel, with some grades selling for as low as $6, by the end of 1998.

It took a 40% drop in prices between October 1997 and March 1998, which sliced billions out of OPEC revenues, before Saudi Arabia was able to orchestrate an emergency agreement to try to rein in production from other OPEC producers, who were loath to lose market share to newly resurgent Iraqi oil exports. Moreover, the crisis had caused investors to pile into safe haven assets, such as U.S. treasury bills, stocks, and other U.S. dollar-denominated assets, which pushed the value of the dollar up by nearly 20% in the six months after the crisis began. Because crude oil is priced in U.S. dollars, the sharp jump in the currency’s worth, relative to other currencies, meant that oil in the United States was significantly cheaper. It also meant that oil was more expensive in many hobbled emerging-market currencies, which exacerbated a decline in demand in those parts of the world. Adding to the demand downturn was a Northern Hemisphere winter that was one of the mildest on record, limiting heating needs. In the meantime, the amount of oil in storage around the world surged going into the winter of 1998, the visible evidence of a glutted market.

Oil was cheap, but whether that was a good or a bad thing depended on who you asked. For American drivers, it was Eden. Car buyers embraced trucks and sport utility vehicles over smaller cars, eschewing fuel-

efficiency in favor of girth and brawn. Why economize on gasoline, consumers reasoned, when low prices allowed you to get more car and more miles traveled for the same outlay at the pump? “What sells these days are the biggest things in the showroom,” one Florida newspaper trumpeted. A new wave of “rough tough land yachts” rolling off assembly lines across the country—the Chevrolet Suburban, the

Lincoln Navigator, and the Ford Expedition, to name a few—could not be produced fast enough to meet demand.

“Bigger may or may not be better,” in the words of the New York Times, but “automakers are scrambling to build the behemoths Americans will buy.” While car buyers raved, oil producers and the companies that serviced them mourned. “Those of us in the oil patch have seen much better days,” lamented an oil-drilling executive in Tulsa. It was an understatement. Oil companies slashed jobs as well as capital expenditures on exploration and production as they struggled to stem the bleeding. Companies took their drilling rigs out of production in droves due to the collapsing value of their product. The number of active oil rigs drilling in the United States fell from 392 in September 1997 to just 111 by March 1999.

But even those measures were not enough. The finances of the world’s major oil companies were in for a shakeup unseen since the U.S. Supreme Court had undone the Standard Oil behemoth a century earlier. With oil prices so low, even the industry’s most powerful players were forced to go to extraordinary lengths. Coming to terms with dramatically altered market realities meant that companies had to find a way to boost efficiencies, contain costs, and leverage technology and human capital to stay in the game. All of these needs pointed toward one strategy, which oil executives — one by one — began to adopt: merge with or acquire a competitor.

A wave of mergers swept over the industry between 1998 and 2002, making many of the erstwhile oil “majors” now the “supermajors.” BP swallowed Amoco in 1998, the largest foreign takeover of a U.S. company. Exxon and Mobil (XOM)

merged in 1999 in an $80 billion deal. TotalFina took over Elf the same year. Chevron (CVX) bought Texaco for $39 billion two years later, the same year that Conoco and Phillips announced their merger. A host of other companies would be touched by the merger mania over these years, some of them now just names from the past: ARCO, Mitsubishi Oil, YPF,Getty, Enterprise Oil, Nippon Oil Company, Amerada Hess, and many others.

The glut had a way of eliciting rosy sentiments about a future of ultra-low oil prices from even the most tenured analysts, which suited American audiences just fine. Bearish market forces, rather than anticompetitive politics were now in the driver’s seat, they argued. “The world is dramatically changed,” observed Robin West, chairman of Petroleum Finance Corporation. The oil market “really is transparent and efficient.” Some predicted a realignment of the oil order, with Middle Eastern producers losing their exalted place in the energy firmament once and for all. “This may be the end of the old OPEC,” opined the chairman of the Petroleum Industry Research Foundation, John Lichtblau. The oil economy had been reborn, with consuming countries like the United States now in the position of privilege, with little threat to the high oil prices of decades past raining on the parade. “In the old days the question was low or high prices, and everything rode on those numbers,” wrote one American energy expert. “Now the question is low or very low prices.” A futuristic array of new information technologies, the growing role of natural gas in the energy mix, and the diverse sources of oil around the world meant that the “industry has changed fundamentally since previous shocks that seemed to portend ever higher prices,” he told Time. “If you are having haunting visions of long lines and $2.50-per-gallon gasoline, relax.”

And yet, amid apparently limitless abundance, a small pocket of obscure analysts were not nearly so carefree. A few lone voices began to warn that the oil industry would soon bump up against unyielding geological constraints, with almost unthinkable implications for world oil prices. Writing in Scientific American in March 1998—the very time at which inflation-adjusted prices were the lowest they had been in 25 years—Colin Campbell, a geologist, and Jean Laherrère, a petroleum engineer, laid out an elaborate case for why the low prices the world had enjoyed up to that point in history were about to disappear for good. They acknowledged that oil analysts in the 1970s had claimed that the world was running out of oil, only to have to eat crow a decade later. But this time was different. “The next oil crunch will not be so temporary,” they ominously warned.

Their bottom line was as simple as it was shocking: The world’s oil production would begin to decline for good no later than 2010, and possibly as early as 2004. “Peak oil”—in other words, the maximum rate of oil production globally—was in sight. After the world had hit peak oil, they argued, oil prices would then start to rise forever, “unless demand declines commensurately.” Just 12 years in the future, they reasoned, the Middle East will have pumped more than 50% of its reserves. With that giant region running on the second half of the tank, the world’s oil production would enter terminal decline. Global reserves would yield less and less of the stuff. “The world is not running out of oil . . . at least not yet,” they wrote. There was still much more to pump. But oil had reached its tipping point. “The end of the abundant and cheap oil on which all industrial nations depend” had finally arrived. Once production begins to taper off, beginning in a decade or so, a new era of endless price hikes would ensue.

Reprinted from Market Madness: A Century of Oil Panics, Crises, and Crashes by Blake C. Clayton with permission from Oxford University Press, Inc. Copyright © 2015 by Blake C. Clayton.