Commodity nations must deal with the demise of a supercycle

The following is from an opinion column that appeared in the Financial Times Friday, September 25, 2015.

The recent collapse in oil prices is part of a larger drama - the last act in the commodity "supercycle" that began more than a decade ago. That is why the 50 per cent fall in oil prices means not only hard times for the petroleum industry but also portends distress for commodity-exporting nations and the world economy.

The commodity boom took off in late 2003 and 2004 with the transformation of China's role in the world economy. Following its accession to the World Trade Organization in 2001, China was no longer just the traditional source of cheap goods, tough competition and a lid on inflation. It also became a huge market in itself. Its voracious appetite for commodities supported the build-out of an entire country. Between 2003 and 2013, China accounted for 45 per cent of the total growth in world oil demand. Commodity producers were caught unprepared and, as they scrambled to add capacity, prices rose from $20-$25 a barrel in the early 2000s to $100 or so in 2011-2013. The conviction grew that this would go on forever.

Then Chinese demand tapered, and new capacity came on stream. China heat became China chill. The IHS non-oil Material Price commodity index peaked in April 2011, and began declining. Over the past year, the decline has turned into a rout. Since July 2014 it is down 45 per cent.

Oil was the holdout. High prices stimulated the development of new supplies, such as shale. US oil output, which was said in 2008 to have peaked, has instead almost doubled in the years since.

But, unlike other commodities, oil prices did not decline. The reason was that the new barrels were offset by the loss of barrels elsewhere: disruptions in key producing countries (most notably Libya) and the sanctions on Iran. In fact, oil prices reached their post-2008 peak of $115 not that long ago, in June 2014, when it appeared that the Islamic State of Iraq and the Levant (Islamic State) might capture Baghdad and move on to the huge oilfields of southern Iraq.

But the Islamic State advance was stopped. Within months the slowing of the Chinese economy became evident, with the official shift from "high growth" to "medium-high growth." Combined with rising US oil output, slower global growth and the temporary return of Libyan oil, this set the stage for OPEC's decision not to cut production, initiating the collapse and a battle for market share.

The downward pressure on oil has been accentuated by the fact that, since the collapse began, Saudi Arabia, Iraq and the US have added about 2m barrels a day of supply to the market, when demand growth is less than 1.5m b/d.

In fact, US oil production in April reached 9.7m b/d, higher than the annual high point registered in 1970.

The resilience of US shale production has been a surprise to the global market. It is the result of ingenuity and lower service costs, combined with focus on high potential prospects by US producers. On the shale side, there has certainly been much room for greater efficiency. IHS' Performance Evaluator finds that just 30 per cent of the new wells in 2014 produced 80 per cent of the new oil.

But efficiency cannot trump prices in the forties or high thirties. Current prices mean distress ahead for many producers and a decline in US output below 9m b/d by spring. At the same time, around the world, projects in early stages of development are being postponed, delayed or cancelled outright.

Those countries that want to bring in new investment will have to be more competitive in their fiscal and other terms, which will require major changes in mindset and policies. All of this will mean a rebalancing of the global oil market over the next two years, with a lot of volatility along the way.

The distress for nations that export oil and other commodities will increase.

I once asked Ngozi Okonjo-Iweala, who served twice as Nigeria's finance minister, what the phrase "petro-state" means.

Her reply: "If you depend on oil and gas for 80 per cent of government revenues, over 90 per cent of exports are one commodity, oil, if that is what moves the growth of your economy... then you're a petro-state."

That definition can be applied more broadly to "commodity-states" that benefited so much from a supercycle and now have to deal with its demise. The results, as they try to adjust their spending, will include austerity, bitterness and failed expectations, battles over budget and debt, social and political turmoil as well as hard economic times.

The script for the final act of the commodity supercycle does not include a very happy ending.

By Daniel Yergin, Vice Chairman, IHS and author of The Quest: Energy, Security, and the Remaking of the Modern World.

Find out more about how IHS can help deal with these impacts - visit Materials Price Index or the IHS Performance Evaluator today.

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.