Understanding Energy Cycles
by Mark Laskin, CIO
Due to weakness in crude oil prices, the investment
community is trying to use the past to understand the
current and future for the energy industry. In order
to better frame that discussion, we looked at
previous cycles to provide insight to the future.
In order to start the discussion of cycles, it is
important to define what a cycle is, and how it
pertains to the energy industry. First, it is important
to ask the simple question “What is a cycle?” And,
more importantly, “What is an energy cycle? A cycle
is, broadly speaking, a business expansion and
contraction, and for most industries that takes about
five to seven years. Exhibit 1 shows a potential sixyear energy cycle, where the price of oil is indexed to
100. During the period, the price of oil fell by about
50 percent and then rose by three times, and ended
the six-year period back at the indexed 100 level. Is
that an energy cycle? There was a business
contraction and a business expansion back to the
original 100.
Exhibit 2 shows the referenced six-year period was
from 1996 to 2001, almost the bottom of the longer
energy cycle. Since many energy projects require
decades to be completed, the longer duration of
energy cycles makes intuitive sense.
Exhibit 1
Source: Bloomberg
Exhibit 2
As a prelude to our investigation of longer energy
cycles, note one other interesting point from Exhibit
2. Observe the different trajectory of oil prices in the
period prior to 1973. There is a clear indication that
a change in pricing regime occurred after 1973,
which will be discussed in further detail later.
In order to better examine the unique nature of
energy cycles, Exhibit 3 looks at the CAPEX-todepreciation ratio of the energy industry since the
1950s. While there are a variety of relevant elements
in this chart, the first is the vertical line around the
1973-74 timeframe. Prior to 1973-74, the Texas
Railroad Commission, by legislation enacted during
the New Deal, managed the supply of crude oil
production within the state of Texas, and, by default,
the price of oil globally. Post 1973-74, OPEC
controlled global markets.
BP Capital Fund Advisors | 8117 Preston Road Suite 260W Dallas TX 75225 | www.bpcfunds.com
Source: BP Stat Review
Understanding Energy Cycles
Page 2
Exhibit 3
So what happened in '73-'74 that was so
pertinent to the energy industry? The Yom
Kippur War, between the Israelis and the Arab
nations of OPEC, occurred. In this conflict the
United States and other Western powers
backed Israel. As a result, the Arab countries of
OPEC decided to seize control of the energy
markets from the Texas Railroad Commission,
and energy industry cycles changed
dramatically.
In looking at the shape of energy cycles in the
two different eras, the cycles would appear to
have very different characteristics. Cycles prior
to 1973-74 were very short in duration and the
amplitude was very low. However, post '73-'74
there were three major periods. First was an
upcycle into the early '80s, and then from the
mid-‘80s until the mid-2000s was a long down
cycle of about two decades. The period since
the mid-2000s has constituted a strong
upcycle. One other thing to note here –
ironically, in both the pre- and post-1973-74
periods, the average CAPEX to depreciation
ratio was approximately 1.75. Given the
natural decline rates of production, in order to
grow oil production through long cycles,
CAPEX needs to be structurally higher than
depreciation. However, the fact that a similar
CAPEX/depreciation existed in both eras
shows fundamental linkage of the
requirement to invest in CAPEX in order to
grow oil supply to meet increasing demand.
One other period of time merits mention –
1986 – because that was the trough of the big
down “CAPEX-to-depreciation” cycle. The
year 1986 has been a time that the investment
community has really focused on as it relates
to current energy markets.
Since 1986 was the beginning of a 20-year down cycle in energy markets, we want
to determine whether or not it is an appropriate analog for the today’s market.
In 1986, crude oil production was about 60 million barrels a day, and in a very short
period of time prior to 1986, the global supply of oil grew by about 12 million barrels
a day from four different areas around the world: Mexico, the North Sea, the North
Slope of Alaska, and deep water Gulf of Mexico. Supply grew by 20 percent. During
that same period, global demand fell by about ten percent due to the proliferation
of nuclear facilities, knocking oil power plants off the power grid. Additionally, the
auto fleet changed quite dramatically from larger American cars to smaller, more
fuel-efficient Japanese cars. The result was a huge oversupply of oil in the market
with excess capacity ranging between 25 and 30 percent. The question is:
“What did OPEC do to fix the oversupply of oil?”
BP Capital Fund Advisors | 8117 Preston Road Suite 260W Dallas TX 75225 | www.bpcfunds.com
Understanding Energy Cycles
by Mark Laskin, CIO
Exhibit 4
In the early '80s, OPEC, in order to bridge this
oversupply, curtailed their oil production, and over
the course of five years cut their output by about 15
million barrels a day, as seen in Exhibit 4.
By reducing crude oil production, the price of oil
remained artificially high, and as a result, more
production came from non-OPEC sources. However,
by 1986 OPEC realized that they had ceded market
share to other countries around the world, and over
time reintroduced their 13 million barrels a day of oil
back into the markets. The crude oil market took
about 20 years to return to supply/demand balance.
So, given the look at historical energy cycles, are there
perspectives to be gleaned from the recent OPEC
decision not to cut production?
Importantly, today’s crude oil market is very different
than the early/mid 1980s. On Thanksgiving Day 2014,
OPEC decided against cutting their production. Today
the oil market is oversupplied by about two million
barrels a day into a 95-96 million barrel a day market.
The supply and demand situation is very different
than was the case in the mid-'80s. The oversupply is
much lower than was the case in the mid-1980s, and
US shale production declines at a much faster rate
than the long-lived supply additions of the 1980s.
What does this analysis mean for energy cycles going
forward? Re-examining Exhibit 3, the OPEC era was
defined by very long duration, high-amplitude cycles.
In contrast, during the Texas Railroad Commission
era, cycles were much shorter in duration with lower
amplitude. In the foreseeable future, the marginal
barrel of oil will come from short cycle and relatively
lower cost regions. That description of future supply
describes US shale production, since shale barrels are
the quickest supply to enter and exit the oil market.
Within US shale production, the most costcompetitive shales are in Texas. So, in many ways, the
pre-1973 era when the Texas Railroad Commission
managed oil supply — an era marked by shorter
cycles with lower amplitude — will serve as a much
more appropriate analog than that of the 1986
timeframe during the OPEC era.
Source: BP Stat Review of World Energy & PIRA
BP Capital Fund Advisors | 8117 Preston Road Suite 260W Dallas TX 75225 | www.bpcfunds.com
Understanding Energy Cycles
Page 4
In the last several months, the market has
clearly focused its attention on previous
energy cycles, and has determined the 1986
analog to be the most similar. We have
examined why the market has focused
exclusively on the 1986 downturn, and
determined a major contributing factor to be
the scarcity of data. Computers became more
widely-used in the workplace in the mid1980s, and as a result, data sets which
preceded the 1980s are more difficult to find.
Given this time horizon bias, the clearest
example of an oil market downturn is the
early 1980s, and that helps to explain the
undue focus on that time.
.
In order to get a sense for the collective
market’s thoughts about the current
downturn, the valuation of the energy sector
— particularly in relation to the rest of the
market — provides unique insight. Exhibit 6
shows the price-to-book value of the energy
sector relative to the entirety of the market
going all the way back to the 1920s. As we
examined this data we found only one time
period where the valuations were as low as
they are today. Unsurprisingly that timeframe
is 1986; the trough that we looked at earlier.
In thinking about what is happening today,
the market has looked to a previous down
cycle and immediately priced the energy
sector down to that level. But we think 1986
is the wrong analog. Instead, we think that
the market should be looking back to cycles
akin to the pre 1973-'74 era, which were
much shorter in duration and lower in
amplitude. If we are correct, it would mean
that the market is oversold today because the
market is using an overly bearish analog for
reference. To the degree that our analysis is
correct that the cycle is less draconian than
1986, today’s energy market provides a
terrific buying opportunity.
BP Capital Fund Advisors | 8117 Preston Road Suite 260W Dallas TX 75225 | www.bpcfunds.com
Exhibit 5
Source: BP Capital, OPEC
Exhibit 6
Understanding Energy Cycles
Page 5
Important Disclosures:
The views in this material are intended to assist readers in understanding certain investment methodology and do not
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Capex to depreciation ratio indicates the growth phrase of the business. A high ratio shows that the business is investing
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