For Oil at Least, This May Not Be the 1970s

Commentary, Taxation, Frontier Centre

Welcome back to the 1970s and no, it’s not just your imagination. The federal Liberals are headed by an academic. Keynesian pump-priming has returned. ABBA, with the recent Meryl Streep movie/DVD, is again in vogue. The Russians are assertive circa 1979 and have invaded another country (see Georgia, last summer). Give it another month and I expect disco to roar back starting with a re-release of Saturday Night Fever on the big screen.

It also feels like the 1980s or early 1990s with federal budgets predicted to produce two deficits in two years in the $30-billion range. (True, I don’t know how it’s possible to be in three decades at once but grant me literary license). And, for Albertans dependent on the energy industry, the price of oil is in the dumps similar to the 1986-to-late-1990s period.

But that last comparison, where the price of oil went south and stayed there for years will not now be repeated, this according to Randy Ollenberger and his employer, the Bank of Montreal (BMO) Capital Markets.

Ollenberger, the managing director for BMO, was in Calgary recently for a CFA Society dinner. He gave his prediction on the years ahead and on Alberta’s most critical industry. Natural gas is going nowhere but Ollenberger and the bank predict an average per barrel West Texas Intermediate (WTI) price for crude of $50 this year, $75 next, $80 in 2011, and $100 by 2015.

Those estimates might seem low compared to the $147 take enjoyed by the industry last July but $80 and $100 are still historically high. To those who think he is optimistic, Ollenberger’s dissent on why oil cannot long stay depressed makes for interesting reading.

To start, he asserts this latest oil market cycle which dates from 2000 is unlike two earlier cycles, the first which spanned the 1973-1985 period and the second which ran from 1986 to 1999.

“A crucial difference between the current cycle and those before it,” writes Ollenberger and his colleagues in a recent analysis, “is that during the earlier cycles, crude oil prices were predominantly determined by supply-side considerations (not enough or too much), whereas in the current cycle demand-side considerations have been the dominant influence.”

I’m simplifying, but his argument is as follows: in the first two cycles, there was demand destruction as there is now. Back then, the world was awash in oil. Now, unlike the earlier two eras, the present abundance is very temporary.

For example, demand destruction in this recession is not likely to be as severe compared to the early 1980s. Back then, the combined effect of U.S. and European weakening hit oil prices hard but they and everyone else in the OECD also mattered more to the price of oil.

In 1979, OECD consumption accounted for 68 per cent of total oil consumption; it counted for only 55 per cent in 2008. Also, in the present post-2000 cycle, the European appetite for oil already moderated due to high taxes on energy consumption. That means the recession’s additional demand destruction in Europe won’t be as consequential for the price of crude.

What will matter on the demand side is non-OECD growth—industrialization and population growth in Asia and elsewhere. While the OECD thirst for oil will drop this year and next, Ollenberger predicts the non-OECD appetite will grow in 2009 and 2010 and almost make up for the OECD decline.

Then, once the current economic slump ends, the supply-demand ratio will tighten up and quicker than most people think. That’s what Ollenberger means by a demand-driven cycle.

Significantly, that increased demand will take place within the context of mostly shrinking reserves. Ollenberger notes that based on global decline rates in supply, “the industry will need to invest US$600 billion between 2008 and 2015 in sustaining capital and a further US$1 trillion for new projects.” Problem: It is those expenditures which are now being reduced as companies try to preserve cash in a $40-per barrel environment.

“This could,” write Ollenberger et al, “give rise to another spike in crude oil prices within the next couple of years when demand growth resumes.”

That will produce some consequences for governments, consumers and others. Green technologies and renewable energy will become more competitive than when crude was priced at $40; consumers will feel pinched if oil prices rise dramatically, obviously, but those employed in the industry will have more job and career options. And governments such as those in Alberta or Saskatchewan that depend on royalties (for the record—far less on oil than on natural gas at least in the case of Alberta) will benefit from a rise in natural resource revenues.

If Ollenberger is correct, and whether one benefits from a low oil price as a consumer or is hurt by it as an employee or investor in the industry, no one should expect an extended repeat of past busts—other similarities to past decades notwithstanding.