How To Annoy A Peak Oil Theorist: The Soft Patch In Oil Prices Is Here To Stay

by: Mehran Nakhjavani


The world has been living with expensive oil for the past decade.

Expensive oil is associated with higher capex on exploration and production.

The current oversupply of oil is a secular, not a cyclical phenomenon: expect the soft patch in oil prices to persist.

One good way of estimating whether oil is expensive or cheap is to take total oil consumption, multiply it by international oil prices, and express the result as a share of GDP. The result is a measure of "oil spend", which, over the past 40 years has gone through three distinct phases.

After the 1973 oil crisis, oil spend spiked up, and while volatile, it averaged around 4.5% of developed country GDP for the next decade or so, which represented a period of "expensive" oil. The second phase kicked in as oil prices collapsed in 1986, and lasted about 17 years, with oil spend averaging around 1.5% of GDP. In other words, we were in a world of "cheap" oil. Over the past decade, the ratio is averaging 3.5%, taking us back to expensive oil.

Expensive oil triggers higher capital spending on oil exploration and production. In the earlier era of expensive oil, oil capex accounted for around 15% of global capex, currently it accounts for nearly a quarter. Unsurprisingly, during the cheap oil era, such capex shrank to just 5% of global capex.

oil spend and capex

The result of the increased capex is increased oil production, which is growing faster than oil demand. It turns out that the world wasn't running out of oil, after all. It was running out of easy and cheap oil, but as the economics of the U.S. oil patch demonstrate, even the new and unconventional sources of supply are seeing production costs decline.

So it would appear that we are at the beginning of what could well be an extended patch of soft oil prices. Strong EM demand growth probably precludes a return to an era of overtly "cheap" oil, but don't expect much upside from these levels. Indeed, there is plenty of oil that is being kept off the market by geopolitics, which, if conditions change, would return to the export channels, and imply an extended period of soggy oil prices.

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