Because of Its Nature, Oil Industry Produces in Cycles

By Robinson, Robin | THE JOURNAL RECORD, November 18, 1986 | Go to article overview

Because of Its Nature, Oil Industry Produces in Cycles


Robinson, Robin, THE JOURNAL RECORD


In the early part of the 20th century, a Russian economist named Nikolai Kondratieff developed a theory on the cyclical nature of business events.

He related the changes in prices of various commodities to find that an interval of approximately 50 years separated peaks of business prosperity.

Since Kondratieff's theory was reported, people have tried to forecast the upturns and the downturns using his theory and plotting the changes in the markets.

Richard Gordon, director of market analysis for Washington-based Petroleum Finance Co., was a tax economist working for Phillips Petroleum Co. when, in 1981, he was asked to develop a schedule on which way petroleum taxes would swing worldwide.

"The rationale is different from Kondratieff cycles - the duration is only 20 years from peak to peak," Gordon said.

Kondratieff had looked at the movers of the world cycle to formulate his theory, but Gordon wanted to know what features of a certain commodity, oil, made it's cycles grow and shrink.

"We believe that you can anticipate the cycle, but it can't be done using the same old procedures," Gordon said.

"The cycle existed for 113 years, and the world has changed, it's something fundamental in the oil itself."

"That's not to say political and external crises are unimportant, but peel aside the externalities, and get to the cycles, then add the political changes. You get a much better perspective if you pull back."

When Gordon was researching the tax questions, forecasters he spoke with said taxes would increase. His next step was determining the rate of increase.

"There's a market to look for oil," Gordon said. "The government charges for the right to look for oil. That's the tax."

People in the industry look for oil because the price of oil is high. When those people join in the competition, the price falls, forcing taxes to fall also.

"Worldwide now, countries are cutting taxes. They are trying to keep the industry in their countries," Gordon said.

"It was a seller's market in the Seventies; it's a buyer's market now. There's not enough money around to buy the right to look for oil."

"The supply function is the key to the problem. It does not increase by incremental steps," Gordon said.

Due to the nature of oil, the industry produces the commodity in cycles.

The oil industry has a history of surpluses, partly because oil often is found in large deposits.

When a large oil field is found and production begins, the market is flooded with the commodity. The surplus drives the price down and exploration and production industries are not as profitable. This leads to a drop in exploration.

The drop in exploration leads to a shortage of the product, since no one is replenishing their reserves, and prices rise in response.

"When every new producing region is slowly depleted, that's when the supply slows," Gordon said. "That's when there's an upturn of the price, which results in an increase in exploration, and an increase in finds, and then you put a huge field on line."

"The industry is extremely competitive," Gordon said. "When a new area is found, they (producers) can quickly bring the new region's capacity on line at about the same time."

The current production cycle is a response to three large fields coming on line: Mexico, Prudhoe Bay and the North Sea.

When that many new production sources come on line at the same time, the market collapses.

"Now, the market will take effect. The high cost supply is being depleted and not being replaced," Gordon said.

"In a few years, only the low-cost oil will be produced."

There is also a cycle from the variation over time of the production capacity of the fields.

Onshore crude oil production will start with a high volume and can't be maintained. …

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