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10 August 2022

How long will the oil price cycle last

This week has seen oil prices fall to levels not seen since before the start of Russia’s invasion of Ukraine. As a global recession starts to bite, the oil industry must realize that the heyday of the past few months is over. Rethink Energy anticipates that it has just two years to get its affairs in order before consumers present an unrelenting squeeze on global oil demand.

Sitting at around $95 per barrel, Brent Crude oil – a global benchmark – is now below the $96.84 per barrel it closed at on February 23. The West Texas Intermediate has dropped below $90 per barrel.

Both have now fallen over 25% since they peaked above $130 per barrel in March. With Russia providing 12% of the world’s oil, skyrocketing prices have been driven by supply-side shortages, as global buyers placed various levels of embargo on Russian oil. These were compounded by OPEC+, with many members struggling to hit production quotas, at a time when much of the world was still in the swing of an economic recovery from Covid-19.

As they often do within price cycles, high commodity prices have now become their own enemy. The market is now being driven by fears of recession, while several other fundamentals are pointing towards a collapse in oil prices in the mid-2020s.

Global interest rates are rising – the US Federal Reserve gave the go-ahead for a 0.75% rise at the end of July. With an increased cost associated with borrowing, economic growth will slow, bringing down the demand for the oil needed to facilitate it. Other commodities such as Copper and Iron have seen similar slumps over recent weeks.

Nowhere is this more obvious than at the petrol pump. High prices are deterring drivers from taking to the road. Figures released by the EIA in the US indicate that petrol demand has slipped to its lowest level since 1996.

The falling oil price is also being impacted by the global effort to bring down prices for these consumers. President Joe Biden has been on recent visits to Saudi Arabia, to try and get the kingdom to produce more oil, while the US and Iran are still attempting to negotiate a return to the 2015 Iran nuclear deal, which could open up Iranian oil to global markets.

The Covid-19 pandemic was always likely to prompt a new supercycle for oil. Pent up demand for oil in key areas of the economy was to sit in contrast with the reduced production capacity of oil companies. These companies had to ditch their inefficient assets to cut costs through the initial price crash of the pandemic, where the cost of oil dipped into the negative in some markets.

While Rethink Energy does not believe that oil demand will ever return to its pre-pandemic levels, it won’t be far off. That being said, fears that the spare amount of global oil production capacity will not be sufficient to reach this demand, are unlikely to be realized.

Unlike previous supercycles though, the fundamentals behind this one were set to make it more dramatic. The price boom for oil between 2008 and 2014, for example, was predicated on a low investment period of 20-plus years, and demand growth over a six-year period. It was followed by a market adjustment that occurred over 6 years.

The recent boom in oil prices comes off the back of less than two years of demand growth and just over two years of reduced investment. The crash to come could occur in an equally compressed timescale. Russia’s invasion of Ukraine will simply draw-out the downturn. It will do nothing to prevent oil prices from plummeting in 2024 onwards, as EVs storm the automotive market.

Despite its refusal to transition to renewables as needed, the oil industry has become more flexible since the pandemic. New production projects are coming online in just half the time that they used to. These projects have also become smaller in size, allowing for more rapid investment cycles, and for oil to reach the market more quickly.

OPEC+, despite its foibles, has also become more reactive. More frequent meetings among its members will allow the market to adapt more quickly to a reduction in demand, while several members have been able to reduce their break-even price for oil significantly over the pandemic, bringing down the floor price that the cartel will be content with. Many countries can now turn a profit with crude prices at just $50 per barrel.

But most importantly, the availability of new clean energy technologies will have huge impacts on the demand-side of the equation. Facing increased public scrutiny on their climate policies, governments are less able to subsidize the price of oil for customers. Customers face a greater exposure to crude prices than they ever have before.

To protect themselves from these costs, drivers will look to electric vehicles, which can be acceptably subsidized by governments. Others will reduce the amount they drive, continuing the push towards working from home to avoid fuel costs. Recession may slow the adoption rates of electric in the short-term, but it will impact the sales of ICE vehicles even more.

For the next two to three years, the boycott of Russian oil will limit how low oil prices can fall, and big oil will remain profitable. Beyond this, their entire existence will depend on how they are investing today.

Oil companies are already acting as expected: upping spending to meet rising oil demand. Capitalizing on this sudden windfall of oil profits, they are racing to repair their balance sheets and reduce debt levels. They are also desperately trying to cling onto investors by hiking dividends and artificially boosting share prices through share buybacks.

The element that they are missing is the rapid and unrelenting investment in new clean technologies, rather than those – like carbon capture – that aim to keep value ascribed to their extensive fossil fuel assets.

The current oil boom presents their last chance to secure funding for their transition. The oil industry will only become more efficient and competitive over the coming years, as companies face a waning demand for oil. This means that future peaks in oil prices will be less dramatic and sustained for less time.