Economist's Corner

Commodity Price Cycles: Explained by an Expert

Gürcan Gülen, University of Texas at Austin

Oil and natural gas are the lifeblood of modern economies. Together, they account for close to 60% of global commercial energy consumption. Even in future scenarios with a high penetration of alternative energy sources or technologies, oil and gas are expected to maintain a share of about 50% by the middle of this century; more business-as-usual scenarios forecast a share of 60% or more.

The transportation sector depends on oil products such as gasoline, diesel, bunker fuel, and jet fuel almost exclusively. The ability to travel and ship goods are the key ingredients for a successful economy; the  lack of transportation infrastructure or its low quality has often been a major roadblock for emerging economies to attract investment. It will be difficult and time-consuming to switch millions of vehicles on land, sea, and air to alternative fuels. None of the alternatives, including biofuels, electric cars, and fuels derived from natural gas, appears to be ready to replace oil products in necessary scale although they are certainly making progress.

What is the Interplay Between Oil, Natural Gas, and Alternatives?

Natural gas is an important feedstock in many industrial processes such as methanol or fertilizer plants, but the growth in gas use has come primarily from the electric power sector, where it has been replacing oil and other fuels (primarily coal) in many countries, in addition to meeting new demand growth. In some markets, more than half of the electricity is generated in gas-fired power plants. The share of natural gas in power generation is expected to increase in most countries as countries try to lower their emissions and as more gas resources are proven and developed across the globe.

The fact that gas-fired power plants are relatively cheap and quick to build has been and will likely continue to be a key driver of this transition to natural gas in the electric power sector. Another driver is the shipping of natural gas in liquefied form, or LNG, as it facilitates the increased use of gas in more markets around the world. The number of LNG-importing countries and regasification capacity tripled while the number of LNG-exporting countries and volume of trade more than doubled since the early 2000s. The low natural gas prices in the US in recent years, mainly a result of the “shale revolution,” encouraged many LNG-export projects; however, low oil prices reduce the competitiveness of these projects. Construction at the Sabine Pass terminal started in August 2012, and Cameron and Freeport in late 2014. Others might be delayed or canceled altogether.

The increasing shares of alternative technologies, including renewables such as wind and solar, and the possible resurgence of nuclear power generation are often seen as threats to the market share of natural gas. However, the capital cost of wind, solar, and nuclear remains high relative to that of gas-fired plants. In addition, wind and solar are intermittent sources of generation, which limits the share of these technologies in making a power grid operate within the reliability standards. Storage of generated electricity can mitigate the problem of intermittency. There are several storage technologies under development and some are commercial or near-commercial projects. However, the sector is still in its infancy and there have been technology and commercial failures. Once commerciality is proven, developing enough capacity to matter for the market shares of different fuels will take time.

Although there is a level of dichotomy between oil-exporting and -importing countries, generally speaking, “lower” oil and gas prices provide a boost to the world economy. High oil prices triggered recessions in the past, especially in those countries that depend heavily on oil imports. Often forgotten, however, is the fact that prices were high at least partially because of demand increasing faster than supply, and that demand started increasing faster because oil was “too cheap” for some period.

Globally, the price of natural gas delivered by pipelines or as LNG is linked to the price of oil through formulas. The oil price could be a reflection of a basket of crudes, or the price of an oil product such as fuel oil. This pricing is a historical remnant of the long-term contracts needed to develop long-distance pipelines and LNG value chains but still reflects the energy security concerns of major importers such as Japan, which is dependent on imports for almost all of its energy needs. High oil prices hurt such importers more as natural gas price also increases, whereas low oil prices help their trade balance more because gas imports also cost less.

In the US, natural gas and oil prices are mostly independently determined in their own markets, even though there are complex and indirect linkages to the prices of byproducts such as ethane and propane, the cost of drilling services, and the substitution of fuels. For example, current low oil prices have led to a drop in drilling activity, which can possibly lead to service companies reducing the fees for their rigs and related services, as well as suppliers of pipes and other field equipment decreasing their prices. This reduction in upstream costs might encourage more gas wells to be drilled at lower natural gas prices.

Why did the Price of Oil Spike in 2008 and Remain High Between 2009 and Late 2014?

These boom-bust cycles result primarily from the inherent time inconsistency between business cycles and the investment cycle of upstream projects, which can be as long as 10 years for conventional projects. The rapid and large economic growth experienced in “emerging” economies, led by China, in the early 2000s led to a significant increase in demand for oil products, but the industry was not ready to supply the required amounts. This “excess demand” situation resulted in increasing prices, which culminated in a significant spike in the first half of 2008. The economic crisis that hit the world in the second half of 2008 was partially caused by these surging energy prices in addition to excesses in financial markets and fundamental macroeconomic weaknesses in many economies, mostly in Europe. The ensuing destruction of demand for oil coincided with increased production capacity, which was the industry’s response to rising prices earlier in the decade. This “excess supply” situation led to a price collapse in 2009. However, oil prices recovered by 2010 and remained relatively high, albeit not as high as in early 2008, until collapsing again in late 2014.

Clearly, there are factors other than the demand and supply fundamentals that impact the price, although eventually these fundamentals govern the price formation. In the short term, even the demand and supply fundamentals are not fully transparent. Moreover, market players have asymmetric information regarding these fundamentals such as the production capacities of different countries (especially the “spare” capacity in the member countries of the Organization of the Petroleum Exporting Countries—in essence, Saudi Arabia), consumption levels and demand growth in various markets, amount of crude oil and products in storage, and energy and environmental policies across the world.

The great majority of the world’s oil resources are controlled by governments, often via national oil companies (NOCs). Their data are often not publicly available, or if available, they are untimely, insufficient, and questionable in quality. This paucity of data regarding resources and NOC operational and financial performance is probably one of the most significant challenges facing analysts trying to understand long-term prospects of the global oil supply. Government policies to subsidize petroleum products inflate demand in many countries; during economic crises, many governments cannot afford the subsidies, the reduction of which further contributes to price cycles. Otherwise, subsidies induce black market activity, which can be significant in parts of Africa, the Middle East, and Southeast Asia, accounting for large volumes when aggregated.

In addition, geopolitical factors and financial trading of “paper barrels” contribute to volatility and cycles. For example, among the most commonly cited reasons for the price spike of 2008 is the increased amount of money invested in commodity trading by relatively new players in this space (institutional investors such as hedge funds and index funds). Some also pointed to several important geopolitical developments including Venezuela stopping supplies to ExxonMobil in February 2008, pipeline bombings in Iraq in March 2008, labor strikes in Nigeria and Scotland in April 2008, militant attacks on facilities in Nigeria from April through June 2008, and reports of declining Mexican exports. Such outages can have a disproportionately large impact depending on the quality of crude production lost, given refinery specifications and emission requirements for fuels in various markets. For instance, lost production of light sweet Nigerian crude could not be readily compensated by heavy sour crude from Saudi Arabia even though the latter’s production capacity is sufficient.

Also of note are macroeconomic policies and developments. In particular, some analysts pointed to expansionist monetary policies and associated low interest rates as well as the weak US dollar as factors contributing to the rise of the oil price during the period leading up to the spike of 2008. Expansionist policies fuel demand, and the weak dollar forces producers to raise their prices to maintain revenues in purchashing power terms. Consistently, some believe that the increased strength of the dollar is contributing to the price of oil remaining low in early 2015.

The same factors are also behind the quick recovery of the oil price after the 2009 collapse. Geopolitical concerns include the string of upheavals in the Middle East (commonly referred to as the Arab Spring), the collapse of the ancien régime in Libya, the Russian aggression in Ukraine, continuing problems in Nigeria and Venezuela, and violence in Syria and parts of Iraq. With such uncertainties, trading tends to add a risk premium to the price. The cost of upstream operations has also increased in the 2000s along with the price of oil and increasing development activity. Other than a brief period of decline after the 2008 crisis, the upstream costs continued to rise. This is partially a result of increasing competition for services and partially the intrinsically higher cost of developing tar sands and tight oil plays. Eventually, though, increasing production (especially in the US unconventional space) led to an excess supply as the European economies continued to struggle and emerging economies, including China, started to falter. Hence, the collapse of the oil price in late 2014.

Although many of these countries continue to grow, the growth rates are much lower than what they used to be in the early to mid-2000s. Many countries have also been adopting policies to increase fuel efficiency and conservation by switching to alternative fuels and technologies. It is too soon to tell how much of an impact these policies will have (and the current low oil price environment certainly reduces the sense of urgency for their implementation), but some analysts believe such transformation could eventually lead to a leveling of global oil demand. In the shorter term, however, the low price will induce increased consumption and rationalization in the upstream sector, which will bring the market to a new equilibrium at a price higher than the recent bottom-of-cycle level. In the meantime, spikes due to significant geopolitical incidents or accidents cannot be ruled out.

For a more detailed discussion of the oil market mechanics within the context of the 2008 spike, please see http://www.beg.utexas.edu/energyecon/thinkcorner/Think%20Corner%20factors%20impacting%20oil%20price.pdf.


Gürcan Gülen is a senior energy economist at the Bureau of Economic Geology’s (BEG) Center for Energy Economics (CEE) at the University of Texas at Austin, where he investigates and lectures on energy value chain economics and commercial frameworks. He has been working in BEG’s interdisciplinary team to assess shale gas and oil resources in the US and CEE’s natural-gas demand assessment in the electric power, industrial, and transportation sectors. Gülen has worked on oil, natural gas, and electric power projects in North America, South Asia, West Africa, and the Caucasus among others, focusing on the economics, policy, and regulation of resource development and delivery, and power market design. He served in the US Association for Energy Economics (USAEE) in various positions and was the editor of USAEE Dialogue for several years. Gülen is a USAEE Senior Fellow and a member of SPE, American Economic Association, and Gulf Coast Power Association. He received a PhD in economics from Boston College and a BA in economics from Bosphorus University in Istanbul, Turkey.