(John Kemp is a Reuters market analyst. The views expressed are
* Volatility slide deck: tmsnrt.rs/2inB4Qe
* Oil price cycle chart: tmsnrt.rs/2jLMB0Z
By John Kemp
LONDON, Jan 13 Extreme volatility and strong
cyclicality have been the defining characteristics of oil prices
and the industry since the first modern oil well was drilled in
Pennsylvania in 1859.
Oil prices are much more volatile than the prices of
manufactured goods or services, and in this they resemble other
industrial and agricultural commodities.
Volatility is apparent at all time scales from the very
short term (tick-by-tick and daily movements in futures prices)
to the longer term (month-to-month and year-to-year).
But price moves are not random and display clear evidence of
cyclical behaviour, again at all time horizons from the very
short term to decades.
Volatility and cyclicality are not incidental features of
oil markets that can be wished or managed away. Volatility and
cyclicality are fundamental characteristics of oil markets.
Prices, production and consumption do not return promptly
and smoothly to equilibrium following a disturbance to the
"The problem of oil is that there is always too much or too
little", Myron Watkins, professor of economics at New York
University, wrote 80 years ago ("Oil: Stabilization or
Conservation?" Watkins, 1937).
"The basic feature of the petroleum industry ... that
matters most is that it is not self-adjusting", according to
economist Paul Frankel ("Essentials of Petroleum", Frankel,
Because of the lack of adjustment mechanisms the industry
has "an inherent tendency to extreme crises" and "hectic
prosperity is followed all too swiftly by complete collapse"
The industry has defied repeated attempts to tame the cycle
and provide greater stability ("Crude Volatility: The History
and the Future of Boom-Bust Oil Prices", McNally, 2017).
LOW PRICE ELASTICITY
Frankel's description has remained accurate for six decades
and his book remains the best short primer on the oil business.
Frankel blamed boom and bust on the sluggish response of
both production and consumption to even a large change in oil
The lack of ready substitutes for oil as a transport fuel
and in petrochemicals ensures consumption responds slowly and in
a limited way to a change in prices.
Capital intensity and the high ratio of fixed to variable
costs in all parts of the supply chain from exploration and
production to refining and marketing ensure supply is also
price-inelastic in the short term.
Low price-elasticity of both supply and demand are what
Frankel meant by lack of "self-adjustment" in the industry.
But other factors beside low-price elasticity contribute to
the extreme instability and cyclicality of oil prices ("Oil
prices: volatility and prediction", Reuters, 2016).
LAGS AND EXPECTATIONS
Given the capital-intensive nature of the oil business,
investments in new production capacity and changes in production
take a long time.
Bringing a complex offshore oil field onstream can take 10
years from discovery to initial production. Training experienced
seismologists, drilling supervisors and petroleum engineers can
take even longer.
The oil industry's mass layoffs during the price slump of
the 1990s were still hampering its ability to increase
production a decade later, contributing to the price boom of the
By their nature, investment decisions must be based on
expectations about where oil prices will be in three to 10 years
when projects come onstream and then over the succeeding 10 to
20 years of field production.
But there is evidence that expectations, which are meant to
be forward looking, are strongly influenced by the recent past,
introducing a backward-looking element.
Oil companies are generally too bullish about future prices
following a boom and too bearish about future prices following a
Backward-looking expectations coupled with lengthy delays in
bringing new capacity onstream contribute to the cycle of under-
The same problem is also apparent on the consumption side
where households and businesses entrench often backward-looking
expectations about future prices in purchases of long-lived
The oil industry is also characterised by multiple feedback
loops which affect the speed of adjustment.
Negative feedback mechanisms dampen the impact of an initial
disturbance and are therefore stabilising and promote a rapid
return to equilibrium.
Fuel-switching, efficiency and energy conservation policies
are all negative feedback mechanisms on the demand side of the
market which promote an eventual return to balance.
Capital budgets, cash flow and the availability of debt and
equity finance all act as negative feedback mechanisms on the
But there are also positive feedback mechanisms which
amplify and prolong the impact of an initial disturbance and are
therefore destabilising and delay return to balance.
Producers' revenue needs and changes in fiscal terms and the
cost of labour, raw materials and service contracts are all
examples of positive feedback loops.
The GDP impact of an oil-price slump on the internal oil
consumption of oil-producing countries is also a source of
positive destabilising feedback.
In the longer term, negative feedback mechanisms clearly
prevail because there are no examples of oil prices rising or
falling without limit.
In the short and medium term, however, destabilising
positive feedback mechanisms may be more important and
contribute to volatility and price cycling.
The oil industry is a series of closely related markets for
crude, fuels, refining, services, engineering, construction,
drilling equipment, skilled labour and raw materials.
Many of these markets themselves exhibit low price
elasticity, delays in investment, backward-looking behaviour and
Each market is subject to its own feedback mechanisms,
operating at different speeds and different time scales.
Rebalancing the oil industry actually means rebalancing all of
these markets simultaneously.
As a result, the oil industry can be thought of as a system
that exhibits very complex and chaotic behaviour where small
changes in one part of the system can trigger very large changes
in the rest of the system.
Complex systems exhibit very dynamic and non-linear
responses with a small change in initial conditions capable of
producing a very large change in outcomes.
Recent experience has shown how a small change in technology
(horizontal drilling and hydraulic fracturing) in one small part
of the oil industry (U.S. shale) helped trigger a slump in
prices affecting all producers.
BEYOND THE SLUMP
The worst of the slump now appears to be over but past
experience implies that instability will characterise the
recovery as well.
In the past slumps such as 1997/98 and 2008/2009 have
usually been followed by a very large rebound in prices (tmsnrt.rs/2jLMB0Z).
Oil prices more than doubled between December 1998 and
December 1999 and again between January 2009 and January 2010.
In the most recent episode, U.S. crude prices have already
risen by almost two thirds, from an average of less than $32 a
barrel in January 2016 to an average of almost $53 so far in
The question is whether the oil market has now fully priced
in the (expected) rebalancing of production and consumption.
Most energy industry professionals think the adjustment is
nearly complete for the time being, with prices this year
expected to average around $55-60, close to current levels, and
only $60-65 in 2018.
Some analysts predict the rise of the U.S. shale industry
will lead to a new oil market structure, with more flexibility
in production, greater price stability and prices capped around
$60 or $70 far into the future.
But past experience suggests the process of adjustment has
rarely been so smooth and orderly and it would be unusual if
this time was different.
(Editing by Greg Mahlich)