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The Hog Cycle And Oil Prices

Industries that have a delayed supply reaction to price (short term price inelasticity of supply) tend to exhibit a cyclical behaviour in supply and price. Delayed responses to falling and rising prices may create price and supply “overshoots”.
 
The hog industry seems to display a regular four-year cyclicality, through the interaction of hog inventory, pig slaughter and price changes[1]. The pig gestation period is about 4 months, the age at slaughter varies greatly depending upon the end product but an average of 6 months may be reasonable, and it takes about 6 months for a female to become ready to breed. Faced with falling prices, a farmer cannot therefore just liquidate his “pigs in progress” inventory. Some are still growing inside their mothers, and even the ones that are born need to grow to a point where they are saleable. In the worst case, it could take about 10 months for the offspring of a newly fertilized breeder pig to be ready for market. Farmers may decide to sell some of their pigs earlier than normal, and also to sell some of the female breeder pigs given that they will be planning to reduce supply. In the short term this will produce a counter-intuitive increase in supply in response to falling prices, which will only exacerbate the price fall.
 
Once these short-term factors have been exhausted, the supply of pigs to the market will start to fall and (independent of other factors) prices will start to rise. As the suppliers look to increase supply in response to rising prices, they face some issues. Firstly, their stock of breeder pigs will take 10 months to produce progeny ready for market. In addition, the previous selling of breeder pigs has reduced their stock and it will take time to replenish them. The time to get a new breeder pig in place, together with the time for that breeder pig to produce marketable progeny, produces an average delay of 20 months. Therefore, the supply reaction to increasing prices will be quite subdued to begin with – exacerbating any price increases. Once all the new breeder pigs are in place, pig supply can be significantly ramped up. Independent of other factors (e.g. a price insensitive increase in pork consumption), prices will then start to fall and the cycle will begin again.
 
The oil industry faces many of the same issues as the hog industry. As the cheap to exploit oil deposits have been heavily utilized, the oil industry has been forced to access much more difficult and costly to exploit deposits. The time between discovery and production, together with the financial resources required to find and exploit discoveries, has greatly escalated. The relative remoteness of many new deposits may also require extensive new distribution and supply infrastructures. The result was a significantly elongated production response to price rises, which exacerbated the run up in oil prices prior to 2008. The relative global short-term price inelasticity of demand (structural limitations to reductions in oil usage, together with economic growth driven increases in demand from developing countries, especially China) added to the run up in prices.
 
The high oil prices supported industry investment in higher-cost deposits, but it took time to marshal the required resources (organizational, physical, and financial) and bring new production online. The recovery in the oil price from the short-term 2008 crash provided continuing support for the required capital raising and long term investments. The Zero Interest Rate Policy (ZIRP) of the Federal Reserve and other central banks aided this process by reducing the cost of capital (therefore reducing financing costs, and reducing the relative attractiveness of other opportunities to investors). A few years later, and these efforts produced increasing supply, especially from shale oil deposits in the United States (7.8 mbpd in 2008 to 12.5 mbpd in 2014) and the Tar Sands in Canada (3.3 to 4.3 mbpd)[2], with the rest of the world’s output relatively stable (new production being offset by depletion and political issues). Once supply exceeded demand, the price of oil started to fall.
 
With the low-cost producers such as Saudi Arabia deciding to maintain production, the oil price was be dependent upon the willingness of the high cost producers to maintain production. With the massive infrastructure costs for the Canadian Tar Sands already spent, it made sense for production to continue as long as revenue was equal to short run marginal costs. The rapid depreciation of the Canadian dollar also shielded the Tar Sands producers somewhat, given the pricing of oil in US dollars. Costs have also been reduced as the labour and oil supply markets have responded to the reduction in new projects.
 
The shale oil producers had many wells in progress, or ready to drill (just like the “pigs in progress”), and these continued to add supply throughout 2015. With some uncertainty about how long oil prices would stay low, and how low they would fall, it also made sense for the shale oil producers to manage production against short-term operating costs. With many shale oil producers having significant debt-financing obligation, there was also the need to keep production going to generate the required cash flow. As with the Tar Sands, the shale oil operators have also benefitted from costs reductions that have reduced their operating break even point.
 
With relatively weak economic growth, increased demand did not quickly remove the supply overhang. The end result has been a price fall from above US$100 to around US$30. Current production has slowly started to react to the low oil price, with the number of shale oil rigs falling. With the high depletion rates of such wells, the resulting production falls will accelerate through 2016. These very high depletion rates are akin to the length of fertility of a breeder pig being greatly reduced, requiring a much increased renewal rate of breeder pigs (oil wells) to keep up supply. The oil industry has also significantly reduced investment in exploration and production[3]. Given the multi-year nature of many such projects, the resulting production shortfalls will not be felt for a number of years.
 
With global oil demand slowly increasing, the supply/demand imbalance (which is not that great[4]) may be worked off over the next couple of years, short of a global economic recession.
 
Given the financial damage done to the oil producers, especially the shale oil producers, the investment response to any rise in prices may be significantly delayed. The sheer volatility of prices in the past decade may also significantly reduce the receptiveness of oil executives and investors to new high cost oil ventures, with the assumed cost of capital being set much higher to reflect the perceived increased risk. This can only add to the price inelasticity of supply, and therefore any future price overshoot.
 
Within a few years the current low prices may be just a memory, as society struggles with escalating prices that do not readily produce a resulting demand response. If David Hughes is correct in his assessment that the shale oil plays will peak quickly and rapidly decline in production due to fast depletion rates and limited “sweet spots”[5], there may be actual declines in production well into a period of rising prices. The result may be an economic recession that reduces demand just as the new supply start to come on stream, producing another price overshoot to the downside. The impact of such price volatility, repeated oil business failures (as well as individual career failures), and the resulting investment losses and bad load write-offs, will reduce even more the readiness to finance new oil investments. If the recession had a significant impact upon the financial system (e.g. bank failures), the ability to finance new oil investments may be even more constrained. I will cover the possibility of an oil industry/financial system positive feedback loop in a future post.
 


[1] John Bancroft (n/a), The Big Hog Cycle - What goes down, must go up?, Canadian Center for Swine Improvement. Accessible at http://www.ccsi.ca/meetings/stratford/john_bancroft_text.pdf
[2] Andrew Bergman (2015), World’s Top Oil Producers, CNN Money. Accessible at http://money.cnn.com/interactive/news/economy/worlds-biggest-oil-producers/
[3] Karolin Schaps & Ron Bousso (2016), Big oil to cut investment again in 2016, Reuters. Accessible at http://www.reuters.com/article/us-oil-companies-investments-idUSKBN0UH0AB20160103
[4] International Energy Agency (2015), Oil Market Report, International Energy Agency. Accessible at https://www.iea.org/oilmarketreport/omrpublic/currentreport/

[5] Steve Horn (2015), Report: Eagle Ford Shale Has Peaked, Lifting of Oil Export Ban Could Drain Field More Quickly, DeSmog Blog. Accessible at http://www.desmogblog.com/2015/12/16/report-eagle-ford-shale-peaked-oil-exports 

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