[Choi Ji-woong's Oil Hegemony War] Why Predicting Oil Prices Is Harder Than Stocks or Exchange Rates

Why Are Uncertainty and Volatility in Oil Prices Inevitable?

Starting from the 7th, Asia Economy Newspaper will publish a biweekly Friday series titled 'Choi Ji-woong's Oil Hegemony War,' diagnosing changes in the international oil order and the future of the energy industry. The author joined Korea National Oil Corporation in 2008, working in the Europe and Africa Business Division and the Stockpile Business Division before completing an Oil and Gas MBA program at Coventry University in London in 2015. Last year, he published the bestseller 'How Oil Rules the World,' which covers the modern history of oil.

In January this year, international oil prices fluctuated between $60 and $68 per barrel. However, as the novel coronavirus disease (COVID-19) spread, oil prices halved in March, dropping to the low $30 range. The sharp decline in oil prices attracted the attention of general investors, leading to a surge in investments in derivatives tracking crude oil prices, such as exchange-traded notes (ETNs). At that time, oil prices had fallen more than 50% compared to the beginning of the year, creating a sentiment that prices would soon rebound. Yet, as if mocking such expectations, oil prices plunged again, with the monthly average price of West Texas Intermediate (WTI) futures falling below $20 in April. Notably, on April 20, prices traded at -$37.63, an unprecedented situation where sellers had to pay buyers to offload oil.

The Oil Market Resembles the Agricultural Market... Close to Perfect Competition
Even with Monopoly and Collusion Maintained through OPEC and IEA, Sharp Price Fluctuations Are Unavoidable

Predicting prices of stocks, commodities, interest rates, or exchange rates is extremely difficult. However, no price or indicator is as volatile as international oil prices. Historically, international oil prices have exhibited volatility that surpasses that of stocks or other commodities. Another market showing similar volatility to the oil market is the agricultural market. Prices of onions or napa cabbage sometimes become extremely cheap one year and as valuable as gold the next. The agricultural market frequently experiences supply-demand imbalances similar to the oil market, and both markets share an important commonality: they are close to so-called perfect competition markets with many suppliers and many consumers.

So, if the oil market were monopolized by a single company, could oil prices stabilize? Attempts to control prices through monopoly have historically persisted in the oil market. In the late 19th century, when the modern oil industry emerged in the United States, John Davidson Rockefeller secured a monopoly by controlling 95% of the U.S. oil industry. He aimed to establish the sole standard for oil by founding Standard Oil and dominating as the oil king through mergers with competitors. Until its breakup under the 1911 antitrust law, Standard Oil controlled crude oil supply alone. For a brief period, it was able to prevent sharp price drops and spikes, maintaining price control. This case later became a benchmark for major oil-producing countries.

In the 1960s, Middle Eastern and South American oil-producing countries, which became the largest crude oil suppliers, sought to regulate supply through the Organization of the Petroleum Exporting Countries (OPEC) cartel. Although OPEC controlled supply and triggered the oil shocks of the 1970s, their influence did not last long. The International Energy Agency (IEA) was established in 1974, with member countries jointly stockpiling emergency oil reserves to offset monopoly effects. More importantly, collusion among OPEC members was not properly maintained. In short, neither Standard Oil nor OPEC could control oil prices. Monopolies were vulnerable to attacks, and collusion was fragile.

Even Monopoly Producers Cannot Predict Oil Production
Demand Cannot Be Forecast Due to Economic Shocks Like COVID-19
Paper Trading of Crude Oil Far Exceeds Physical Trading, Increasing Volatility

If monopoly and collusion were properly maintained, could oil prices be stably maintained without sharp rises and falls? It might be possible in the short term, but in the long term, sharp fluctuations are unavoidable. There are three reasons for this.

Choi Ji-woong, author of 'How Oil Rules the World,' working at the Oil Information Center of Korea National Oil Corporation

First, even monopoly producers cannot predict oil production. Current technology cannot accurately determine how much oil is underground. Historically, estimates of oil reserves and production forecasts have often been wrong, and even today, exploration success rates rarely exceed 30%. Even for producing oil fields discovered through successful exploration, production cannot be precisely controlled like factory output. The pressure and lifespan of underground reservoirs essential for crude oil production are largely beyond human control.

Second, while supply adjustment is difficult, demand is also unpredictable. Due to the COVID-19 crisis, oil demand in the second quarter of this year decreased by nearly 20%. This sudden demand drop was unforeseen by anyone. Even excluding exceptional situations like COVID-19, oil demand is heavily influenced by macroeconomic factors that are difficult to predict, such as economic cycles, growth rates, inflation, and unemployment. Oil demand, dependent on unpredictable economic environments, is itself unpredictable.

Lastly, in the oil market, there are far more traders participating for brokerage or arbitrage purposes than those trading for actual physical crude oil needs. Today, paper trading without physical oil backing occurs at 20 to 30 times the volume of physical trading on commodity exchanges in New York and London. Various transactions for investment, speculation, brokerage, and price hedging increase oil price volatility. The negative WTI futures price in April occurred as traders rushed to close long positions before contract expiration to avoid physical delivery.

Historically, a Certain Pattern Repeats After Low Oil Prices: High Oil Prices Follow
Currently, Unprecedented Investment Decline Due to Low Oil Prices
Increasing the Likelihood of High Oil Prices Returning in Several Years

However, the oil industry's consistent patterns amid unpredictable high and low oil price trends provide small clues for long-term price forecasts. Typically, high oil prices have increased investment in oil exploration and development, while low price trends have suppressed it. This has caused supply-demand imbalances with a time lag. The oil shocks and subsequent high prices of the 1970s promoted new oil field developments in the North Sea and Alaska, leading to increased supply and triggering the 1986 oil price crash.

History repeated itself between 2010 and 2012 when the 'Arab Spring' anti-government protests swept through the Middle East and North Africa, sustaining high oil prices and stimulating new investments in U.S. shale oil fields. This led to a continuous decline in oil prices from 2014 to 2016.

The current situation in 2020 is the exact opposite of the previously mentioned patterns. With oil prices plummeting, global oil development investment this year is expected to decrease by about 30% compared to last year. Some U.S. shale companies have filed for bankruptcy protection, and major oil companies have canceled or postponed investment plans. The longer the COVID-19 crisis continues, the greater the decline in investment will be. After a five-year trend of decreasing oil development investment since 2014, COVID-19 is further reducing investments significantly.

Oil field development takes from as short as one year to over ten years. Therefore, the current investment slump may cause supply shortages at some point in the future when the economy recovers, even if not immediately. Of course, the future cannot be predicted with certainty. However, the unprecedented investment decline now increases the likelihood of a return to high oil prices in several years. This is especially true considering the overwhelming volatility oil prices have historically exhibited.