Get ready for the coming oil glut
Investors are assuming that energy prices will stay high. History suggests the opposite, says Max King
After the oil price soared in the 1970s, it was almost universally assumed that it would continue to rise relentlessly. BP’s annual review of the market in 1970 had stated that the world had just 25 years of reserves left so rising demand and limited supply meant that prices could only go one way.
In reality, higher prices curbed consumption by encouraging a drive to energy efficiency, while new discoveries were made and extraction rates improved. Supply exceeded demand and the oil price crashed. By 1995, when the oil was supposed to run out, BP was estimating that there were 50 years of reserves left.
The oil price surged again in 2008, reaching $147 a barrel, fell to $40 in the financial crisis and then recovered to $100. In 2014, it crashed again as fracking in the US increased supply. In the pandemic, the oil price briefly went negative as demand fell.
Experience of the past 50 years therefore tells us that surges in price are met by a response in both demand and supply and the price then falls back. Oil intensity – the volume of oil consumed per unit of growth – has fallen steadily, halving since 1984 even though demand has risen by two-thirds since then. The constraint of the oil price on the global economy continues to fall.
Optimists vs pessimists
Yet the current assumption is that oil and gas prices will at least stay high if not go higher. The optimists believe that an oil price of around $100 a barrel is here to stay – which still means that inflation should fall as the increases in the past year drop out of the comparator numbers. The pessimists believe Russia’s wild forecast that the price is heading for $300 a barrel. John Templeton’s advice – “this time, it’s different” are the four most dangerous words in the investor’s vocabulary – has been forgotten.
Longview Economics is almost a lone voice arguing that a coming oil glut will drive prices down again. “If oil prices remain at current levels, there will be a significant supply response over the coming 12-18 months which will generate a global supply surplus /rising oil inventories in 2023,” say analysts there. Demand will continue to grow by 4.1 and 3.8 million barrels a day (bpd) in 2022-2023, although this growth – on top of 2021 demand (similar to 2019) of 100 million bpd – may prove high as it assumes no effect on demand from higher prices. With the IMF forecasting a sharp slowdown in growth this year and next (from 6.1% in 2021 to 3.6%) and much of China in lockdown, slower demand growth looks likely.
Longview expects supply to rise for three reasons. First, Russian oil production, which accounts for more than 10% of world supply, should remain high. In the short term “there are already signs that oil production is falling sharply” due to Western sanctions but “exports have remained relatively robust”, according to tanker data. There are plenty of Asian buyers happy to buy at discounts of $30 a barrel while the effectiveness of sanctions invariably fades over time.
The media assumption, pessimistic as always, is that the war in Ukraine will last for years. This is possible, but it is equally possible that Russia will be decisively defeated. If so, Europe will be anxious to resume imports of oil and gas as soon as possible, especially if they came through Ukraine.
Longview also expects production from members of the Opec+ producer group to continue to increase steadily. Six producers – Saudi Arabia, Iraq, the United Arab Emirates, Kuwait, Algeria and Russia – have spare capacity, while production in Iran and Venezuela is likely to recover. Venezuelan output fell 85% in the 15 years to 2020, but has subsequently doubled. It needs to blend its heavy oil with lighter oil, which it can buy from Iran and Russia. Additionally, shale production in the US is growing rapidly, with high prices incentivising expansion.
Lower inflation and rising markets
This adds up to 4.6 million bpd of extra output this year and 4.7 million next, with the excess supply bringing prices down sharply. This would feed through into lower petrol and gas costs for both consumers and businesses, causing inflation to drop. Wages that have lagged inflation on the way up would also lag on the way down, raising living standards.
Louis-Vincent Gave of Gavekal estimates that a $40 drop in the price of a barrel of oil would release $400bn of liquidity into the global economy. This in turn should reverse the recent strengthening of the dollar. Lower fuel prices in 2023 could bring not just lower inflation but also higher living standards, a weaker dollar, improved liquidity, a pick-up in growth and corporate profits and rising equity markets.
In the longer term, increased investment in renewables and nuclear power, together with improving energy efficiency, will further erode demand for fossil fuels, so the hydrocarbon intensity of growth will continue to decline, possibly at an accelerated pace. This is not the last time that oil and gas prices will spike upwards but, despite the inevitable global pessimism that such spikes bring, they are likely to get shorter, less frequent and less economically damaging. It really isn’t different this time.