Explained: Why The Oil 'Lesson' of 1986 is Wrong

January 16, 2015 Topic: Oil Region: United States Blog Brand: The Buzz

Explained: Why The Oil 'Lesson' of 1986 is Wrong

The aftermath of 1986 was almost inevitable at the time given the investment that had already happened. What happens over the next decade in oil markets still remains very much to be determined.

 

When I was on the road promoting The Power Surge in 2013, I regularly said two things: First, oil prices could easily plunge for a year or two, though it was far from certain that that would happen. Second, we would not see a repeat of 1986, when the hangover from a price crash lasted for well over a decade before high prices finally returned.

As oil prices have fallen, it’s been pleasantly surprising not to see people trot out the 1986 episode as evidence that we might be in for a decade or more of low oil prices once again. Earlier this week, though, a Bloomberg writer decided to buck the trend with “Oil Collapse of 1986 Shows Rebound Could Be Years Away”. The “Chart of the Day” from that article, reprinted here, pretty much tells the story.

 

But 2015 isn’t 1986.

Then, massive investment in oil production following the twin oil crises of the 1970s led to a buildup of long-lived oil production capacity. With money spent, that production capacity cost very little to operate. Prices needed to stay low for several years to throttle not only new investment but also production back. Non-OPEC oil production fell every year between 1988 and 1993.

Weak demand also played an important role. While consumption originally rose after 1986 in response to lower prices, between 1989 and 1993, world oil consumption rose by a mere 1.5 million barrels a day, dragged down by the collapse of the Soviet Union and economic weakness more broadly.

The biggest difference today is the supply picture. In 1986, the world faced an overhang of conventional oil production capacity. Today, it is buffeted by a surge in tight oil production. The difference is stark. Once investment in tight oil stops, output from existing wells drops sharply, which is very different from what happens with conventional wells. This can, in principle, balance the market much more quickly than was possible in the 1980s.

Of course investment in U.S. production hasn’t come to a halt. That’s why most analysts still expect supply growth this year. But this is a fundamentally different situation from the mid-1980s. If oil prices stay low for as long as they did after 1986, it will be because tight oil production turns out to be massively scalable at remarkably low prices while remaining profitable, not because sunk investment costs have created oil producing zombies that continue pumping at almost any price. (It could also happen if the world rapidly accelerated the deployment of low-cost alternatives and efficiency.) The aftermath of 1986 was almost inevitable at the time given the investment that had already happened. (This brackets the far-from-inevitable decisions by Saudi Arabia and others to boost their own production after 1986.) What happens over the next decade in oil markets still remains very much to be determined.

This piece first appeared in CFR’s blog Energy, Security and Climate here.

Image: Flickr.