Son of Oil Bust

February 1999By Comments

MY WEST TEXAS FRIEND, WHOSE FATHER HAD been in the oil business and who by now had been in the oil business himself for nearly forty years, was gloomy, gloomy, gloomy. “I’ve never seen the Permian Basin this quiet,” he said. “Watch the rig count. That’s the main thing to watch, and the rig count in the Permian Basin has never been so low. There were only twenty-seven in Texas last week versus over one hundred this time last year. It didn’t get that low in ’86, and we thought that was awful. Now we are going to see something we are not familiar with. Now we don’t have second-tier companies who will absorb whoever is laid off from the bigger ones. It’s a real fundamental change. You can’t just hunker down and get through it. This isn’t a bunch of guys who were overspending. I don’t care how conservatively you manage your business, you can’t make it if your product is suddenly worth half what it used to be. I know a man who laid off his son. You know it’s rough when you lay off your son.”

The news of the huge merger between Mobil and Exxon highlighted the equally important news that the price for a barrel of oil was in a free fall. For ten years the price had fluctuated between $17 and $24. But by late December it was at $10.75, the lowest price in 26 years when adjusted for inflation, although by early January it had climbed back to $13. The layoffs my friend had alluded to hit everywhere. Halliburton in Dallas announced it would lay off 2,750 employees. For Baker Hughes of Houston, the number was 3,500. Across the state the total number of layoffs could be as many as 40,000 or even 50,000 people. As if that weren’t enough, the Los Angeles Times reported that the Houston Petroleum Club’s annual Fellowship Lunch in December served three hundred fewer prime ribs and three hundred fewer oyster soufflés than it had the year before. This all comes at a time when we are still at a standoff with Iraq, even after bombing them once again. The threat of a major disruption in the Middle East didn’t affect the price of oil at all.

In the United States we seem not the least concerned that oil supplies might dry up. My friend’s gloom seemed like a lonely cry compared with the bust of the eighties, when everyone was affected. Now, West Texas oil towns will suffer yet again and Houston will feel some effects, but the rest of Texas should be unaffected. The notion, prevalent in the seventies, that oil was a finite resource and might run out before the end of the century sounds quaint today. Oil never did go to $50 and certainly not to $100, as many supposedly reliable experts predicted back then. The earnest scolding about conservation, the 55-miles-per-hour speed limit, the automobiles that sacrificed comfort and performance for fuel efficiency, the efforts to develop alternate fuels like ethanol and alternate energy sources like wind or solar power—these all sound quaint as well. Oil has been cheap for fifteen years. These days in Texas we pay 50 cents per gallon in taxes, which means that gasoline itself costs less than 50 cents per gallon. That’s cheap energy, about the same as or less than we have been paying for thirty years.

Oil is a peculiar commodity in that, paradoxically, it can be sold in a stable free market as long as someone controls the price. Once the internal-combustion engine created major demand for oil, and once there were huge fields of oil discovered, it became apparent that pumping the fields dry as quickly as possible would produce so much oil in excess of demand (and destroy the fields at the same time) that the price could only go lower and lower. A producer could limit production, but that would force the price back up only if all producers limited production. In the end that is just what happened. When Texas controlled the world supply of oil, the Texas Railroad Commission, to enforce orderly drilling in the fields, set production levels for wells in Texas and thus controlled the world price. In the seventies the OPEC nations controlled the supply of oil and, by voluntarily limiting their production, controlled the international price. Over time, OPEC meetings have developed into a complicated form of liar’s poker. The members are all countries whose income is almost entirely from the sale of oil. Each country has its individual idea of what income it needs, and one country may want more income than the OPEC production limit would allow. A frequent response to this dilemma has been to lie. A country may lie about its level of production by claiming it to be higher than it is. Then if it is asked to cut production, it can cut “paper barrels” that were never going to be produced in the first place.

Nevertheless, the system has kept prices stable for fifteen years—until now. There are two basic reasons for the fall. One is Asia’s economic problems, which have reduced demand in oil’s biggest growth market. The second, far more important, involves Iraq, which, beginning in June, was allowed under the embargo to sell $5.2 billion worth of oil every 180 days. Since Iraq does not have the capacity to produce that much oil every 180 days, that decision effectively removed its oil industry from embargo, and Iraqi oil flowed onto the market. Meanwhile, OPEC countries, notably Saudi Arabia, did not cut their production. Thus there was an overabundance of oil and the price fell. This is how a decision on the other side of the world forces a man in Midland, Texas, to lay off his son.

What happens next? There are three principal theories. The first is the Return of OPEC Theory. In early January Ron Chernow, the author of the recent Titan: The Life of John D. Rockefeller, Sr., argued in the New York Times that while recent exploration in the former Soviet Union and elsewhere and improved recovery techniques have reduced OPEC’s share of the world market to 40 percent, the lower prices mean that “OPEC may be on the threshold of a new hegemony. Now that crude prices have sagged to such low levels, each further dollar decline will bankrupt more high-cost competitors [Texas oil companies among them] and widen the Arabs’ market share.”

“Wrong,” says oil analyst Dale Steffes of Houston, “plain-ass wrong.” Steffes is a maverick oil-price prognosticator who now runs his consulting business out of his home. He presents the Decline of OPEC Theory. Steffes did correctly predict in 1985 that oil would stay at $15 for fifteen years. And in 1985 dollars it has. He doesn’t make public predictions about price anymore, but he has refined his forecasting techniques in the intervening years. They factor in a mixture of economics, technology, human desires and frailties, and his belief that the supply of oil in the world is infinite for all practical purposes. He predicts that by 2003 the United States’ share of world production will fall by 1 percent; that Mexico’s and Canada’s share will grow by 1 percent; that South America’s share will also grow by 1 percent; and that the shares of the former Soviet Union, Africa, and Asia and Oceania will each grow by 2 percent, all of which nets out to a growth of 7 percent share of the market outside the Middle East. Thus he reasons that the Middle East’s share must fall by 7 percent. That’s a “trend discontinuity,” as he puts it, since he believes the Middle East will lose market share even though it is the low-cost producer.

George Littell is a partner in Groppe, Long, and Littell in Houston, a firm that is also in the business of forecasting oil prices. He offers the Everyone Should Stop Overreacting Theory. He agrees with Chernow that the Middle East’s share of the market will rise. Littell also believes that the gloom in the Texas oil industry is temporary because the price in 1999 will be around $20 per barrel most of the year. The reason? “Production outside OPEC will decline, and Iraq, which is more rational than Saudi Arabia, will emerge as the controlling factor in the industry.” He thinks that the supply of oil is infinite, although it’s not that simple. “First you run out of cheap oil, then you run out of moderate oil, then you start running out of expensive oil. There will always be oil, but at a price.” He thinks that, with prices low, now would be a good time to increase taxes on gasoline even more. “No one would notice at the pump right now, and the higher price in the long run would encourage conservation.”

Paul Bjacek is the director of the world petrochemicals program of SRI Consulting in Houston. He has his own version of the Don’t Overreact Theory. He believes that, despite the current low price, there will be an increase in oil company exploration as part of a battle for market share, especially overseas. “The companies think that if they don’t go get the oil, someone else will, and they want to expand their production base out of OPEC countries. The big producers outside of OPEC want to get more power in determining prices. That’s what is behind the big mergers because they will make some of the big companies almost equal in reserves to some of OPEC’s minor partners. When the return of demand in Asia brings prices back up, they will be ready.”

Oil’s share of the Texas economy has fallen from about 20 percent to 7 percent in less than twenty years. We haven’t been betting on oil as we did fifteen years ago, so when the industry suffers, what was once a blow to the stomach in Texas is now more like an annoying pinch. Oil has joined ranching in becoming that combination of myth and anachronism that Texans find so seductive. There will always be an oil industry here, and there will always be wildcatters raising money to drill another well, just as there will always be ranchers running some cattle on the range. Like ranching, oil is both a business and a way of life, almost an ideology, but like ranching, oil needs to work as a business to work as a way of life or else it becomes a sort of weekend diversion for those whose real life is somewhere else. The children of the son who was laid off will likely have to look for another vocation.

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