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People go through a lot of trouble to explain things. If the market goes up or down, analysts are quick to attribute things like wars, jobs data, interest rates, etc as the reason for the market going up or down. Sometimes these signals are confusing too. Recently, you may have heard inflation data as a reason the stock market declined, just for the same result in later months to produce the opposite result.
While we can attempt to attribute rational explanations to the market, humans are emotional, and like it or not, the markets reflect that. Keeping with the oil theme this month, supply gluts are often a reason used to explain crashes in the price of oil. Last week I discussed the current natural gas glut, expressed by low prices in the US. The natural gas glut is very prominent, evidenced by negative pricing in certain regions and the geographic liquidification constraints leading to large discrepancies in world regions. On the other hand, it is less obvious to me that oil supply gluts are the primary culprit of oil price collapses in the past. With oil being the most important energy market in recent memory, the most extreme price drops were in the 80s, late 2000s, mid-2010s, and 2020.
80s
The 1970s were famous for their oil spikes and issues as I discuss in Crude Awakening. With domestic peak oil fears and the OPEC oil embargo, the oil price skyrocketed. This is a textbook example of “the best cure for high prices is high prices,” as the US suffered two recessionary periods in the early 1980s. Of course, other factors like interest rates under Volker and conflict in the Middle East contributed, but alas the oil price promptly declined (especially in inflation-adjusted terms).
In this case, Saudi Arabia was cutting oil production into the price decline to keep prices up. After growing tired of other nations’ lack of cooperation in these efforts, they couldn’t go any longer constraining their domestic supply and allowed production to resume freely. This can help explain the sharp decline in 1985 and served as a catalyst for further downside in the price.
2008
Before the financial crisis, oil was propelled higher by accusations of economic mismanagement in the US from OPEC, a rampant housing bubble, and further tensions in the Middle East. This blowoff top in price has yet to be regained, in nominal or inflation-adjusted terms. While the exuberance of the economy at the time encouraged the oil price to rise, the party eventually came to an end, and hard. With bank failures and a severe recession that followed, the oil price promptly crashed as well.
Since oil is foundational to driving, manufacturing, and more, the economic slowdown resulted in lower demand for oil. Since supply is less elastic than supply, the price moves down fast because of the severity of the recession.
Mid-2010s
Peak oil did not manifest as many expected as new technological discoveries allowed for unconventional drilling techniques and access to new natural gas reserves within the US. The proliferation of shale natural gas production and its use as a heat and electricity source is often cited as a reason for the oil glut or price drop in the mid-2010s.
While a supply surplus is a theme of any glut, an often overlooked explanation is the economic struggles at the time. Some European nations faced default around this time and the European Central Bank even began emergency loans programs to keep companies alive. In the US, a small manufacturing downturn was also taking place. Lastly, Saudi Arabia and OPEC this time advocated more production in an attempt to discourage shale oil and gas in the US (to no avail).
2020
In hindsight, the oil price drop in 2018 and the inverted yield curve ahead of the COVID pandemic may have foreshadowed something to come. Not many if any saw the global pandemic coming. The recession, precipitated in large part by mandatory shutdowns of many parts of the economy resulted in a steep crash in the oil price. With policy moving quickly and oil supply still on the market, futures prices actually went negative on major exchanges.
With swift and unprecedented economic stimulus, the driver for a rebound in economic activity and oil prices at the tail-end of the pandemic played out.
Conclusion
There may be a chicken/egg point here, which came first the lower demand or extra supply? Either way, the common theme underlying each of these areas is the recession or economic slowdown. Sure, there was mismanagement by OPEC, new shale oil supply, and disruptions in the Middle East, but even in these cases, there was also lower demand from the economy. An oil supply glut can more holistically be predicted historically by a demand glut.
There are several implications to take away from this. First, it shows how important it is to consider economic factors in energy markets, which are often overlooked. Whether it is by oil, renewables, or nuclear, downturns in demand for all or any may be more due to recessionary factors than problems with the technologies and their rate of adoption/downfall. Economic factors are very important and will disrupt the adoption and trajectory of renewable energy for example, as you often see predictions of straight line and even exponential growth rates in them.
Second, it implies that recession may reduce demand in the short term, but this doesn’t mean that long-term demand will peak as the IEA suggests. There is a chance that a sharp drop in oil prices in the future could be an argument as evidence renewables are taking over and oil’s days are numbered. I laid my case last week on why oil demand will continue to grow even as renewables grow, albeit with disruptions in demand from economic factors along the way. Utlimatly, history advocates my point that we should keep a close eye on the economy and markets as well as the fundamental technologies. Until next week,
-Grayson
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