Less than a week into 2015 and already oil is down 9 percent for the year. Oil prices fell below $50 a barrel on Monday for the first time since April 2009. By Tuesday, oil traded below $48. It wasn’t that long ago that analysts were gasping at the prospect of $70 oil, a threshold oil moguls and petro-states would be relived to by anywhere near by the end of 2015. Breaking through $60 was seen by a lot of well-paid people as a likely floor. But that was three weeks and $12 ago.
I was in Houston the day oil first fell below $60, at a chamber of commerce lunch heralding the strength of the local economy—40 percent of which is based on oil. Despite the Texas-sized grins, you could sense the panic starting to creep in.
Talk to a commodity analyst these days and you’ll probably hear about the “commodity super-cycle,” a wonky term to describe the way that supply and demand for things like oil and copper move in a slow, decades-long dance that eventually repeats itself. As supply moves from periods of scarcity to surplus, prices rise, fall, and then rise again, killing demand before fueling more of it along the way.
Jeff Currie, head of commodity research at Goldman Sachs, pays particular attention to this interplay. Over the past century, he says the average length of an oil supply cycle is about 25 to 30 years. That puts the current sell-off right on time, considering it’s coming almost exactly 29 years after the oil bust of 1985-86. Both sell-offs are the result of too much supply: In the 1980s, it was the Saudis who flooded the market, while this time around it’s frackers in the U.S. pouring millions of new barrels onto the market.
Oil prices crashed in a similar fashion in 2008 but for a different reason. After several years of rising prices, oil got so expensive that demand dropped. As the global economy crashed, oil fell from $148 a barrel to $40 during the last half of 2008. Throughout that sell-off, however, the futures market stayed optimistic. Oil contracts four, five, and six months into the future remained relatively high, meaning oil speculators always thought prices would soon rise, which they did. ”You really didn’t have much of a chance to trade that market back then,” says Currie.
This time around, the futures market has tanked along with current prices. A barrel of oil for delivery in July is only a few dollars more expensive than it is right now, meaning oil speculators think low prices are here to stay. If they come back quicker than expected, a lot of money can be made.
The market has reached what Currie calls the “exploitation phase” of the oil cycle, where years of investments fueled by high prices have unlocked a long-term supply. This is essentially the reward. After the crash in the mid-1980s, oil prices stayed low for more than a decade, helping fuel a sustained period of economic growth. With any luck, the same will happen this time around.
But with lower prices come lower investments, which will ultimately lead to fears of shortages and higher prices and the start of another commodity cycle. For now, though, the entire oil industry is getting repriced downwards. “We’re moving down the cost curve and eating away at the fat that’s developed in the system,” says Currie.
By fat, he means the roughly $90 billion in debt issued by junk-rated energy companies over the past three years. Drilling for shale oil in the U.S. is an expensive endeavor. A horizontally-fracked well produces most of its oil and gas within about 18 months, so companies need to drill faster and faster just to keep pace. Many of them were spending more than they were bringing in. It was only a matter of time before that caught up to them, particularly considering how high the yields were on their debt.
“High yields are the markets telling the world to quit using capital in this way,” says Currie. Now that caital will search for a new, safer home.
