Oil Markets: Don’t Mistake Short-Term Changes In Futures And Options Prices For Long-Term Changes

By Ed Hirs, Energy Economist

The global market for crude oil is roughly 34 billion barrels per year, or about 93 million barrels per day. Journalists ponder and report every flicker on the screens of oil traders, akin to the play-by-play analysts for sporting events.

In a recent article, Reuters’ senior market analyst John Kemp points to a very large increase in net long positions by “hedge funds,” raising fears that hedge funds are pushing up prices too soon and setting up the market for a quick fall.

Kemp further states that Hedge funds and other money managers held futures and options contracts equivalent to 791 million barrels of crude betting on a further rise in prices and just 128 million barrels gambling on a fall.”

But he oversimplifies.

Traders in crude oil futures and options contracts fall into two broad categories: oil companies or “market participants” on the one hand, and all others, “financial participants,” on the other.

For one thing, not all financial participants are hedge funds, because many other players fall into the financial participant category, including airlines, trucking and shipping companies, utilities and industrial users of petroleum products.

Second, financial participants aren’t necessarily “gambling” but doing just the opposite. Many are simply hedging against future price movements in order to bring some certainty to an aspect of their overall business.

Finally, there is the implication that the total long position by financial participants is a significant number relative to the size of the overall market. It is anything but; 800 million barrels – roughly the amount Kemp notes as subject to options and futures contracts betting on higher prices – represents less than 10 days of worldwide consumption, and the oil futures and options markets have contracts that extend for more than seven years. That 800 million barrels is less than 2.4 percent of the annual global market and less than 0.35 percent, just thousandths of the expected consumption over seven years.

The key point is this: the small size of the options and futures markets relative to the overall size of the market is what makes the options and futures markets so volatile.

Academic research indicates that the Brent and WTI forward price curves are poor predictors of future prices — very much like the forward prices in foreign exchange markets or agricultural commodities markets are poor predictors of prices realized in the future. The dynamics of the oil markets are played out day-to-day at the wellhead and refinery gate for producers, and at the pump for retail consumers. The volatile oil commodities markets provide some indication of prices in the very near term — days and weeks — but less so for months-ahead prices and hardly any guidance for years-ahead prices.

The real usefulness of the oil commodities markets is to provide a very small group of risk-averse consumers and producers the ability to lock in prices and assure level costs and profits at least until it is time for the annual bonus review. Those who mistakenly think that they indicate anything more are simply off the mark.

Ed Hirs teaches energy economics in the University of Houston’s College of Liberal Arts and Social Sciences. In addition, Hirs is managing director for Hillhouse Resources, LLC, an independent exploration and production company. He founded and co-chairs an annual energy conference at Yale University.

UH Energy is the University of Houston’s hub for energy education, research and technology incubation, working to shape the energy future and forge new business approaches in the energy industry.


Is It 1987 Yet? The Fracking Bust Keeps Rolling On

By Bill Gilmer, Director of the Institute for Regional Forecasting

The 1982-87 oil bust is the industry standard for tough times. Complaints about falling oil prices and rig counts can always be countered with “At least it isn’t as bad as the 1980s.” But there is no question that times are very tough now.

The last seven quarters have been a brutal setback for American oil, with the price of crude falling by $64 per barrel, the rig count down 70.2 percent and capital spending off by nearly 60 percent. This downward spiral showed no signs of slowing in the first quarter of this year, as the 698 rigs working at year’s end dropped by a third to 464 in late March. When the number of U.S. working rigs hit 488 on March 11, it set the low mark for the 67 years that Baker Hughes BHI +0.58% has conducted its weekly survey.

Early on, no one expected the current fracking bust to be this deep, and it is worth revisiting 1982-87 again for a careful comparison to the present. Among modern drilling downturns, if we use such measures as length or the percentage decline in oil prices and rig count, the current downturn has clearly moved into second place in terms of severity.

comparison of oil market events

However, there are at least two dimensions in which this fracking bust is much worse – the speed of the fall in drilling activity and the decline in total capital spending for exploration and production. This downturn has come much faster and harder than any other.

Comparing tough times – then and now

Since the 1970s, the U.S. has experienced five major downturns in drilling activity: the Oil Bust of the 1980s, the Asian Financial Crisis (1997-98), the 2001 U.S. recession that came with the end of the tech bubble (2001-02), the Great Recession and Global Financial Crisis (2008-09) and the current Fracking Downturn that began in 2014. If we are looking for the most serious downturns in depth and length, the Big Two easily stand out as 1982-87 and the on-going setback in fracking.

Beyond severity, the Big Two share another important characteristic. Both were driven by large new oil supplies. Oil came from the North Sea, Nigeria and Alaska in the 80s, and the new oil comes from fracking today. In contrast, the other three downturns were brought on by recession and a collapse in oil demand. The Asian Financial Crisis, the 2001 recession and the Great Recession all triggered a major drop in oil demand, oil prices and drilling. The 1982-87 bust was initially triggered by a severe U.S. recession in the early 80s but soon assumed a life of its own based on large new oil discoveries. The Fracking Downturn is accompanied by solid U.S. growth and weak but continued global expansion. Like the 1980s, today’s drilling collapse isn’t about the economy, but about too much oil in the market.

The table below compares the 1982-87 Oil Bust and the fracking downturn on three dimensions: the decline in the real price of oil, the fall in the rig count and the cut in real capital spending.  Dollar values are in constant 2015 dollars, and quarterly averages are used to avoid the brief extremes that often come at oil market peaks or troughs. Sources of data are described in a box at the end of this post.

At first glance, 1982-87 looks worse, especially if you focus on percentage declines. Oil prices fell 74.1 percent in 1982-87 and today – so far – they are down 66.4 percent; for the rig count, the drop in the 1980s was 82.4 percent vs. 70.2 percent now; and capital spending in the 1980s was cut 85.5 percent, vs. the current 59.7 percent.

The 80s also come out far ahead on the length of decline, lasting between 19 and 25 quarters, depending on the measure you choose, while the current downturn still covers only seven quarters. That said, the fracking bust is now longer than any of the other three demand-driven events. The only exception in any of the other three downturns, for any measure, is an eight quarter drop in oil prices in 1997-98.

However, there are two important measures that argue the Fracking Downturn is worse than the 1980s. One is the speed of decline. After seven quarters in 1982-87, oil prices had fallen only 30 percent, the rig count by 47.5 percent and capital spending was down only 48.4 percent.  For each of these measures it would be 1986 before that decades oil bust matched the percentage declines already registered in the last seven quarters.

The drilling collapse in 2008-09 is the only rival for the rate of speed of the current drilling implosion, and it was triggered by a very fast-moving financial crisis. It lasted only four quarters.

The second measure that sets this downturn apart is the $143.4 billion fall in capital spending for exploration and production.

The figure below illustrates an issue with our comparisons, showing the behavior of both real capital expenditures and the rig count from 1973 to the present. The rig count peak in the fourth quarter of 1981 was 4,222, a figure never matched again, while the 1980s capital expenditures peaked at $87.3 billion.  Compare that to 2008, with the rig count near 2000, and real capital expenditures having soared to more than $300 billion.[1]

The difference, of course, is the change in industry technology. In 1982, a simple vertical well cost less than $500,000 in today’s dollars, while drilling and fracturing a modern horizontal well might cost between $6 and $8 million. Running 2,000 rigs today runs up a much bigger bill than 4,400 rigs in the 1980’s.

real capital spending compared

So how bad is it now? This downturn is not yet as deep or long as 1982-87, but it has come muchharder and much faster than anything that followed the 1982-87 peak. The $143.4 billion of capital spending lost in the last seven quarters is nearly twice the total losses in real capital expenditures sustained between 1982 and 1987. In fact, the inflation-adjusted losses already exceed – and by a wide margin – everything being spent on U.S. exploration and production at the 1982 peak.  No wonder that 2015 saw the entire U.S. economy briefly shudder with the sudden collapse of oil-related spending and employment.

data used for drilling cycle

In the figure, note the double-dip after 2008, and the decline in cap ex that continues afterward.  The first dip is the 2008-09 drilling downturn, and the second is the collapse of natural gas prices and gas-directed drilling in 2013.  Roughly 15 percent of the rig count was quickly lost to low gas prices, and only about half those rigs returned to work directed to oil.  But cap ex continues to fall after 2013 for three likely reasons: fewer gas-directed rigs, productivity gains in fracking that reduced costs per well, and growing price competition for fracking services with new entrants to the service industry.  These trends makes it difficult to time the decline in cap ex specifically associated with oil prices, and to mark the peak in cap ex in the present oil-price cycle.  I conservatively set the cap ex peak in 2014 Q2, the same quarter as the peak in oil prices and the rig count.

Bill Gilmer is director of the Institute for Regional Forecasting at the University of Houston’s Bauer College of Business. The Institute monitors the Houston and Gulf Coast business cycle, analyzing how oil markets, the national economy and global expansion influence the regional economy. 

UH Energy is the University of Houston’s hub for energy education, research and technology incubation, working to shape the energy future and forge new business approaches in the energy industry.