One of the most frequent questions WTRG receives is "Why doesn't OPEC just cut production? They will increase total revenue." This article explains one of the major problems OPEC faces each time it meets. It is the third in a series on crude oil pricing issues.

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The Independent Producers' Dilemma

The cost and crude oil pricing problems faced by Independent Producers. This update is the second in a series on crude oil pricing issues.

The recent downturn in crude oil prices will as usual have the greatest immediate impact on the exploration segment of the industry. Coincident with that will be a decline in sales and manufacture of oil and gas equipment. The next segment of the industry to feel the pressure of the price decline will be the oil and gas services. This page will address the causes for the precipitous drop in prices in an historical context. If you find it of interest you might want to bookmark the page and check back often.  We will be adding to this analysis on a regular basis.  Of course, if you need help determining the impact on your company please contact WTRG Economics.

Oil Prices behave much as any other commodity with wide price swings in times of shortage or oversupply. The domestic industry's price has been heavily regulated through production or price controls throughout much of the twentieth century. In the post World War II era oil prices have averaged $19.27 per barrel in 1996 dollars. Through the same period the median price for crude oil was $15.27 in 1996 prices. That means that only fifty percent of the time from 1947 to 1997 have oil prices exceeded $15.26 per barrel. Prices have only exceeded $22.00 per barrel in response to war or conflict in the Middle East. 

If long term history is a guide, those in the upstream segment of the crude oil industry should structure their business to be able to operate, hopefully  with a profit, below $15.00 per barrel half of the time. 

Pre Embargo Period
Crude Oil prices ranged between $2.50 and $3.00 from 1948 through the end of the 1960s. 

The price oil rose from $2.50 in 1948 to about $3.00 in 1957. When viewed in 1996 dollars an entirely different story emerges. In 1996 dollars crude oil prices fluctuated between $14 - $16 during the same period.  The apparent price increases were just keeping up with inflation. 

From 1958 to 1970 prices were stable at about $3.00 per barrel, but in real terms the price of crude oil declined from above $15 to below $12 per barrel.  The decline in the price of crude when adjusted for inflation was further exacerbated in 1971 and 1972 by the weakness of the US dollar. 

OPEC was formed in 1960 with five founding members Iran, Iraq, Kuwait, Saudi Arabia and Venezuela.  By the end of 1971 six other nations had joined the group: Qatar, Indonesia, Libya, United Arab Emirates, Algeria and Nigeria.  These nations had experienced a decline in the real value of their product since foundation of the Organization of Petroleum Exporting Countries. 

Throughout the post war period exporting countries found increasing demand for their crude oil and a 40% decline in the purchasing power of a barrel of crude.  In March 1971, the balance of power shifted.  That month the Texas Railroad Commission set proration at 100 percent for the first time.  This meant that Texas producers were no longer limited in the amount of oil that they could produce.  More importantly, it meant that the power to control crude oil prices shifted from the United States (Texas, Oklahoma and Louisiana) to OPEC. 
 

Yom Kippur War - Arab Oil Embargo
In 1972 the price of crude oil was about $3.00 and by the end of 1974 the price of oil had quadrupled to $12.00. The Yom Kippur War started with an attack on Israel by Syria and Egypt on October 5, 1973. The United States and many countries in the western world showed strong support for Israel. As a result of this support Arab exporting nations imposed an embargo on the nations supporting Israel. Arab nations curtailed production by 5 million barrels per day (MMBPD) about 1 MMBPD was made up by increased production on other countries. The net loss of 4 MMBPD extended through March of 1974 and represented 7 percent of the free-world production. 

If there was any doubt that the ability to control crude oil prices had passed from the United States to OPEC it was removed during the Arab Oil Embargo.  The extreme sensitivity of prices to supply shortages became all too apparent. Prices increased 400 percent in six short months. 

From 1974 to 1978 crude oil prices increased at a moderate pace from $12 per barrel to $14 per barrel.  When adjusted for inflation the prices were constant over this period of time. 

Crises in Iran and Iraq
Events in Iran and Iraq led to another round of crude oil price increases in 1979 and 1980. The Iranian revolution resulted in the loss of 2 to 2.5 million barrels of oil per day between November of 1978 and June of 1979.  In 1980 Iraq's crude oil production fell 2.7 MMBPD and Iran's production by 600,000 barrels per day during the Iran/Iraq War. The combination of these two events resulted in crude oil prices more than doubling from $14 in 1978 to $35 per barrel in 1981. 

Did the policy achieve its goal? In the short term the recession induced by the 1973-1974 crude oil price rise was less.  However, it had other effects as well.  In the absence of price controls U.S. exploration and production would certainly have been significantly greater. The higher prices faced by consumers would have resulted in lower rates of consumption: automobiles would have had higher mileage sooner, homes and commercial buildings would have been better insulated and improvements in industrial energy efficiency  would have been greater than they were during this period. As a consequence, the United States would have been less dependent on imports in 1979-1980 and the price increase in response to Iranian and Iraqi supply interruptions would have been significantly less. 
 

From 1982 to 1985 OPEC attempted to set production quotas low enough to stabilize prices. These attempts met with repeated failure as various members of OPEC would produce beyond their quotas. During most of this period Saudi Arabia acted as the swing producer cutting its production to stem the free falling prices. In August of 1985, the Saudis tired of this roll.  They linked their oil prices to the spot market for crude and by early 1986 increased production from 2 MMBPD to 5 MMBPD.  Crude oil prices plummeted below $10 per barrel by mid year. 

A December 1986 OPEC price accord set to target $18 per barrel was already breaking down by January of 1987. Prices remained weak. The price of crude oil spiked in 1990 with the uncertainty associated Iraqi invasion of Kuwait and the ensuing Gulf War, but following the war crude oil prices entered a steady decline until in 1994 inflation adjusted prices attained their lowest level since 1973. 

The price cycle then turned up. With a strong economy in the United States and a booming economy in Asia increased demand led a steady price recovery well into 1997.  This came to a rapid end when the impact of the financial crisis in Asia was underestimated by OPEC.  In December, OPEC increased its quotas 10 percent to 27.5 MMBPD but the rapid growth in Asian economies had come to a halt.  If the EIA's crude oil price forecast is on target, this year will, on an inflation adjusted basis, surpass 1994 as the worst year for oil prices since 1973. 

Drilling and Exploration

At  the end of the Arab Oil Embargo in 1974 rig count was below 1500. It rose steadily with regulated crude oil prices to over 2000 in 1979.  From 1978 to the beginning of 1981 domestic crude oil prices exploded from a combination of the the rapid growth in world energy prices and deregulation of domestic prices. Forecasts of crude oil prices in excess of $100 per barrel fueled a drilling frenzy. By 1982 the number of rotary rigs running had more than doubled. 

It is important to note that the peak in drilling occurred over a year after oil prices had entered a steep decline which continued until the 1986 price collapse. The one year lag between crude prices and rig count disappeared in the 1986 price collapse. For the next few years the towns in the oil patch were characterized by bankruptcy, bank failures and high unemployment.

Technological improvements were incorporated: 

• Increased use of 3-D seismic data reduced drilling risk.
• Directional and horizontal drilling led to improved production in many reservoirs.
• Financial instruments were used to limit exposure to price movements.
• Increased use of CO₂ floods to improve production in existing wells.

U.S. Rotary Rig Count
Percent Exploring for Crude Oil

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Rig count does not tell the whole story of oil and gas exploration and development. It is certainly a good measure of activity, but it is not a measure of success. 

After a well is drilled it is either classified as an oil well, natural gas well or dry hole. The percentage of wells completed as oil or gas wells is frequently used as a measure of success.  In fact, this percentage is often referred to as the success rate. 

Immediately after World War II 65 percent of the wells drilled were completed as oil or gas wells. This percentage declined to about 57 percent by the end of the 1960s. It rose steadily during the 1970s to reach 70 percent at the end of the decade. This was followed by a plateau or modest decline through most of the 1980s. 

Beginning in 1990 shortly after the harsh lessons of the price collapse completion rates increased dramatically to 77 percent. What was the reason for the dramatic increase? For that matter, what was the cause of the steady drop in the 1950s and 1960s or the reversal in the 1970s? 

Since the percentage completion rates are much lower for the more risky exploratory wells, a shift in emphasis away from development would result in lower overall completion rates. This, however, was not the case. An examination of completion rates for development and exploratory wells shows the same general pattern. The decline was price related as we will explain later. 

Some would argue that the periods of decline were a result of the fact that every year there is less oil to find.  If the industry does not develop better technology and expertise every year, oil and gas completion rates should decline. However, this does not explain the periods of increase. 

The increases of the seventies were more related to price than technology. When a well is drilled, the fact that oil or gas is found does not mean that the well will be completed as a producing well.  The determining factor is economics. If the well can produce enough oil or gas to cover the cost of completion and the ongoing production costs it will be put into production.  Otherwise, its a dry hole even if crude oil or natural gas is found.  The conclusion is that if real prices are increasing we can expect a higher percentage of successful wells. Conversely if prices are declining the opposite is true. 

The increases of the 1990s, however, cannot be explained by higher prices. These increases are clearly the result of improved technology. The increased use of and improvements to 3-D seismic data and analysis combined with horizontal and and directional drilling. Most dramatic is the improvement in the the percentage exploratory wells completed. In the 1990s completion rates have soared from 25 to 45 percent. 

Oil and Gas Well Completion Rates
Development

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U.S. Oil and Gas Well Completion Rates
Exploration

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Workover rig count is a measure of the industry's investment in the maintenance of oil and gas wells.  The Baker-Hughes workover rig count includes rigs involved in pulling production tubing from a well that is 1,500 feet or more in depth. 
Workover rig count is another measure of the health of the oil and gas industry. Most workovers are associated with oil wells. Workover rigs are used to pull tubing for repair or replacement of rods, pumps and tubular goods which are subject to wear and corrosion. 

A low level of workover activity is particularly worrisome because it is indicative of deferred maintenance.  The situation is similar to the aging apartment building that no longer justifies major renovations and is milked as long as it produces a positive cash flow. When operators are in a weak cash position workovers are delayed as long as possible. Workover activity impacts manufacturers of  tubing, rods and pumps. Service companies coating pipe and other tubular goods are heavily affected. 

This update begins a series on crude oil pricing issues on a new page by examining some of the conflicting goals of OPEC members.

Impact of Prices on Industry Segments

More on the relationship between drilling and completion
Oil and Gas Manufacturing Equipment
Oil and Gas Services

Details of the current collapse
Potential for recovery