Like all other commodities, crude oil experiences major changes in price at times of actual or perceived shortage or glut. These periods are called shocks. The modern world economy, (from the 1980s onwards) has experienced three such instances of shock: the 1986 oil price collapse, the First Gulf War and the recent period of financial turmoil.
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Like all other commodities, crude oil experiences major changes in price at times of actual or perceived shortage or glut. These periods are called shocks. The modern world economy, (from the 1980s onwards) has experienced three such instances of shock: the 1986 oil price collapse, the First Gulf War and the recent period of financial turmoil. Over these three periods the fluctuation in monthly oil price (called volatility) has increased significantly, with month-on-month price changes exceeding 34%. Characterising each of these shocks has been a downturn in exploration and appraisal (E&A) activity across the offshore industry, as the high risk, CAPEX intensive nature of this work becomes unattractive when the value of the future payoff is uncertain. This dynamic has affected most regions; however the North Sea, with a high propensity of independent operators that have been hit by decreasing credit availability, the lack of a large national oil company able to dig deep into reserves of tax payers’ money, and a relatively higher cost basis than emerging regions, has been acutely hit by this process. This has led to a marked decrease in rig utilisation and associated day rates across the North Sea, leading many of our clients to ask us when the volatility will exit the market, and when will business return to usual?
By way of answering these questions, we have recently spent time analysing the current shock in relation to previous ones, using statistical analysis to forecast future volatility in the market. The current shock is demand driven, and unique to those which preceded it. The 1980s oil glut was caused by Saudi Arabia breaking line with the OPEC cartel, turning up the taps, and creating a surplus of oil in the market, causing oil price to drop. The first Iraq war caused many to fear for the potential loss of supply to the market, so prices started to rapidly rise. As the fundamentals of demand remained relatively unchanged through these periods, once the oversupply was corrected, or the fear of undersupply abated, then we were quickly able to return to a situation of business as usual. Looking to the current shock, supply concerns are not the immediate issue, instead lack of demand is causing uncertainty in pricing. Global energy demand reached fever pitch last year, driven by population growth, the expansion of consumerism and the rapid development of emerging markets such as India, China and Brazil. The offshore industry was working at full capacity to ensure energy supply met demand, and the steadily rising oil prices, which typified the last three years, meant that many attained good rewards for their efforts. This however was brought to an abrupt end with the financial crisis, as the tools that had created easy access to credit for the individual and business alike started to unbundle. This precipitated a negatively spiralling situation, which resulted in falling rates of economic growth in all regions. A truly global crisis.
By our count, we have currently endured four quarters of financial and pricing instability, which has had a noticeably depressive effect on E&A activity around the world. The longest of the previous crises, the 1980s oil glut, lasted for six quarters, whilst the effects of the First Gulf War lasted for only three. Current levels of volatility in the market indicate that the present shock is likely to outlive that of the 1980s oil glut. However, crucially, we have already started to witness a decrease in month-on-month oil price volatility levels, with price volatility falling from 17% in May to 16% in June, and standing at 15% to date in July. This decreasing volatility bodes well for future business. However, it should be noted that we are still some distance from the accepted levels of volatility, which characterised the time periods 1991 - 1999 (5.4%) and 2000 - 2007 (6.4%). Away from purely quantitative reasoning, further positive signs can be found in the recent reports of growing activity in Asia, which posted increases in both exports and domestic demand last quarter. Looking at the root cause of the current shock, the banking system, we are still a way off from having all the appropriate international checks and balances necessary. However, the recent repayment of loans from many of the banks that borrowed to avoid going bankrupt suggests that they are starting to find their feet again. Taking all these factors into consideration, we believe that by as early as Q1 next year we could start to see the mindset of uncertainty being replaced by one of optimism, with business as usual potentially returning as early as Q2/Q3. After a slow year in 2009, this will no doubt be a great relief for those involved in E&A across the world.