10
◼ REMARKS Bloomberg Businessweek July 29, 2019illustration of how a slowdown in demand can kill the price
of oil, look back to the last recession. The price of WTI plum-
meted from $145 a barrel to $34 a barrel in just five months,
from July to December of 2008, the worst period of the global
financial crisis.
Although nothing as extreme as the financial crisis is in the
forecast, demand for oil is growing more slowly than supply.
For decades, China was a reliable source of demand for oil
andothercommodities,butitseconomicgrowthrateis ona
downwardtrajectory.Itssecond-quartergrossdomesticprod-
uctexpansion,6.2%,wastheslowestinalmost 30 years, and
economists are expecting it to dip to 6% in 2020. China has also
been making massive additions to its oil inventories, which has
had conflicting effects. On the one hand, the purchases have
added to global demand and thus put a floor under the price.
Ontheother,theexistenceofthehugestocksis puttinga ceil-
ingontheprice,becausetradersknowthatif there’sa supply
disruption,Chinacandrawonbarrelsit alreadyhasinstorage.
“In 2016 Chinahadroughly 50 daysofcoverage.Todaythey
have 100 days of coverage—more than the U.S.,” energy econ-
omist Philip Verleger wrote in an email.
It’s often assumed that the price of oil determines the price
of refined products such as gasoline, diesel, and jet fuel. But
Verleger says the opposite is often closer to the truth. If the
prices of refined products fall because of a glut, refiners reduce
how much they’re willing to pay for crude oil, the main input,
so the price of crude falls. That’s what’s happening now, he
says. China is a leading culprit because it has excess output
from new refineries and is dumping it on the Singapore mar-
ket, Verleger says.
The price of oil is notoriously volatile because both the
supply and demand for it are inelastic. They don’t change
much in the short term in response to changes in price. On
the demand side, drivers need to fill their tanks whether gas
is cheap or costly. On the supply side, producers aren’t able to
increase production rapidly in response to stronger demand,
and they tend to keep producing even when demand declines.
They’ll dump oil on an oversupplied market as long as the price
exceeds the cost of getting it out of the ground.
At least that’s the way it’s always been. The shale revolu-
tion is changing the equation, making supply more respon-
sive to price changes. In contrast to, say, a deep-water well off
the coast of Brazil, a shale-oil project is relatively cheap to get
started, so nimble shale producers can quickly increase pro-
duction if the price rises, putting a ceiling on the price. The
downside of shale is that while it’s easy to find, getting it out of
the ground is costly—more like mining than traditional oil pro-
duction. If oil is too cheap, shale becomes uneconomical, and
shale operators can and do quickly shut in production, reduc-
ing global supply and putting a floor under the price.
This, in a nutshell, is why the shale revolution bedevils
OPEC. It tends to moderate the price of oil and limits the orga-
nization’s power to engineer the market. Shale particularly
confounds one OPEC member: Iran. It can’t credibly threaten
to induce a global recession by harassing tankers, becauseif thepriceofcrudestartstojump,U.S.shaleproduction
willrapidlyincrease—outofproducers’self-interest, not out
of patriotism. The Permian, Bakken, Eagle Ford, and other
sources of shale oil are as valuable to U.S. foreign policy as
the U.S. Navy’s Fifth Fleet.
Iran isn’t completely without leverage. An all-out assault
by it on tankers, loading platforms, and other oil facilities in
the Gulf would wreak havoc. That could happen if hard-liners
in Iran control policy and conclude that nothing short of such
an action will get the country relief from U.S. sanctions, which
have produced double-digit unemployment and reduced its
oil output to the lowest since 1986. This may be a stretch, but
it’s worth recalling that Japan’s sneak attack on Pearl Harbor
in 1941 came after the U.S. punished the country economi-
cally with an embargo on oil and gasoline exports to it. But
a major action by Iran in the Gulf would anger China, a huge
customerofMideastoil,andcouldprovokea militarycon-
flictwiththeU.S.InaninterviewwithBloombergTVinNew
YorkonJuly17, Iranian Foreign Minister Mohammad Javad Zarif
said Iran has the ability, but not the desire, to shut the Strait
of Hormuz. Said Zarif: “The Strait of Hormuz and the Persian
Gulf are our lifeline.”
That leaves Iran with a strategy of sporadic but compara-
tively low-level harassment of Gulf shipping. “It’s almost like
they benefit by dragging it out,” says John LaForge, head of
real asset strategy for Wells Fargo Investment Institute. But as
in the ’80s, the effectiveness of such a strategy—call it uncon-
ventional warfare—diminishes over time. Says LaForge: “The
marketmayjustbefallingasleepwithit.”
Thenagain,thisis theMiddleEast:Youneverknowwhat
willhappen.Pricesdidpopa bitrightaftertheJuly19 incident
involving the two U.K.-linked ships. Before that, Georgetown’s
Talmadge ran through a series of reasons why there’s not much
to worry about, and then, in her email, pivoted to this: “All
that being said, a major, unanticipated military conflict in the
Strait would almost certainly cause at least a temporary spike
in the price of oil.” For now, the oil market is Trump’s friend
and Iran’s enemy. Let’s see how long that lasts. <BW>Brentcrudeoil,dollarsperbarrel* Oilproduction**,barrelsperday
U.S. SaudiArabia RussiaMarket Forces$110703018m14106
1/2005 7/2019 2000 2018
DATA: INTERCONTINENTAL EXCHANGE, U.S. ENERGY INFORMATION ADMINISTRATION*NEAR-MONTH FUTURES CONTRACT. **TOTAL PETROLEUM AND OTHER LIQUIDS.