The Independent Market Observer

Oil Prices Collapse: Is the Energy Industry Going Back to the Future?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Sep 21, 2017 2:49:39 PM

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oil pricesEnergy, in particular the oil and gas industry, has always been one of the foundations of both the economy and the financial markets. The world has run on oil and gas for decades, to the extent that oil prices have been among the key determinants of recessions and market crashes. In recent years, that impact has been just as strong. The rise in oil prices in the 2000s—and the recent collapse—shook economies and governments around the world.

When you look at the cause of this collapse and the subsequent market behavior, however, some interesting parallels to history emerge. In my view, these parallels can help us understand what has happened and, more important, what is likely to happen next.

The past: Wildcatters to fracking

First, let’s consider where the oil industry came from. It was originally dominated by “wildcatters,” cowboys who drilled as much as they could, anywhere they could. When overproduction crashed prices, they declared bankruptcy and moved, starting over when prices rose again.

Then, a handful of businessmen, John Rockefeller chief among them, took the industry and organized it. The group bought and controlled larger and larger parts of the whole, until it was in a position to manage production and prices. Standard Oil, at its peak, pretty much owned the industry and could set prices at will. At least this was the case until it was broken up into the smaller (but still huge) companies that we think of as the U.S. oil industry even today.

A similar scenario played out at the international level. Countries produced and sold as much oil as they could, until the arrival of OPEC (the Organization of Petroleum Exporting Countries) brought them together to manage and limit production—and force prices up much higher. As a competitive market, oil prices crashed. When a monopoly or oligopoly took over, prices rose to everyone’s benefit. Small wonder, then, that countries around the world replicated Rockefeller’s playbook.

All of this worked, of course, until cheating became too rewarding. But prices were still much higher than they would have been, as open competition and production were kept out of the market. Then came the fracking revolution.

Fracking brought the return of the wildcatters, thousands of small companies drilling when and as fast as they could. These companies produced as much as possible in order to pay their bills and, consequently, drove prices down to levels that had not been seen in decades. The energy industry, which had developed in an era of prices managed by OPEC, got hit hard.

The present: Solving the oversupply problem

Which brings us to now. The collapse in oil prices largely solved the oversupply problem, as many of the smaller companies went bankrupt. It also laid the groundwork for a return to a more managed price structure. Large companies could now buy up those assets on the cheap, taking a much larger share of production—and enhancing their ability to once again keep prices higher than they would have been in a free market.

Back to the future?

I suspect that the next 10 years will be very similar to the later stages of the last industry consolidation, as this process continues. The economy and investors will see stable prices, which has largely been the case since the initial collapse. But we will also see prices that increase over time, which so far has also been the case. Oil will no longer be a free market, with the wild price cycles that entails, but a more managed one. In many respects, it will look much more like, say, the 1990s than the boom period (in oil prices) from 2003 to 2008 or the bust period from 2014 to recently.

Overall, the effects should be positive. Markets and the economy thrive on stability. While the collapse in oil prices was a tailwind for many sectors, the damage to the energy sector wiped out many of those gains. Moving forward, energy should be neither a significant headwind nor tailwind, but a solid foundation—which is what a sector this vital should be.

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