The global oil price this week rose to the $50-a-barrel mark and, for the first time since it began a downward spiral two years ago, seems to have ended the lowest stretch of this current price cycle. The behavior of the price of oil over the past two years has important lessons, particularly as we look to prevent or address future energy disruptions.
A key lesson is that concrete physical supply and demand is the main factor that influences the price of oil. Over the past two years, we saw that pronouncements from the Organization of the Petroleum Exporting Countries and other producers would move the price for a couple days, but it was only developments that affected or reflected changes in actual supply and demand that created long-term price changes.
The price rise this past week illustrates this point: it was a direct response to the release of data that showed a decrease in the quantity of oil stored in the United States, which tells us that demand is now outstripping supply. Concrete factors—supply outages in Canada, Libya, Nigeria, and Venezuela, and projected production decreases in Iraq—brought about this shift. These supply reductions are coupled with increased demand in China and India and the anticipated higher summer demand in the United States.
A second lesson we learned was that no matter how many times we hear that oil prices are cyclical, we tend to believe the present trend is here to stay. Assuming low oil prices were here to stay, policymakers by and large refrained from major energy security discussions and Americans purchased more and larger vehicles. The past two years have seen the largest drop in investment in new oil production, setting the stage for the next price surge.
And, in fact, the low point in this cycle was not even very low. The price for most of the past year and a half has averaged around $30 a barrel—in today’s dollars, that’s very close to the average global oil price for most of the past forty years.
A third lesson was that oil price predictions by financial institutions are generally inaccurate, and tend to project forward current trends. Even well-informed analysts often ignore the cyclical nature of oil prices. Over the past two years, long-term predictions were revised almost bimonthly, and on the eve of the 2008 financial crisis, Goldman Sachs predicted oil will go to $200 a barrel. Within weeks, the price crashed along with the US economy. In the past year, while the oil price cascaded downward, Goldman Sachs incorrectly predicted it could reach $20 a barrel. A notable exception was Citigroup’s oil maven, Ed Morse, who through most of this price cycle was spot on in his predictions.
With these lessons in mind, it’s important that we look determine the factors that will influence the direction of oil prices in the future.
On the supply side, the level of resilience of US shale production will be one of the biggest factors affecting the direction of the oil price. The current higher price should serve as a signal for increased production. On a technical level, US shale producers are able to quickly rev up new production. However, production could be impacted by the state of resilience of financing for new drilling and production and how fast companies and banks are willing to jump back into new production. A large number of companies in the US oil patch have gone bankrupt in the past year. Banks and other investors may be hesitant to move back quickly into expanded production after suffering significant recent losses.
Supply could also be reduced by geopolitical events, such as more widespread conflict in Iraq, civil war in Yemen, and a protracted low-simmering conflict between Saudi Arabia and Iran. On the other hand, it seems that there is now greater clarity regarding Iran’s post-sanction production and the price of oil has risen even after the re-entry of Iranian oil in the market. Iran is edging close to its pre-nuclear sanctions production capacity, and the speed of this return may indicate that there was a lot more Iranian oil in the market under sanctions than was earlier acknowledged.
One important factor affecting future demand is that a number of countries took advantage of the low oil price to do away with or reduce domestic fuel subsidies. As the price of oil rises, consumers in these countries will feel the pinch. This should reduce consumption. However, the reduction of subsides could then trigger protests and some states may reinstate these subsidies, at least partially, in response. Some other oil producers could reduce their domestic fuel subsides as part of reforms aimed at adjusting to the still modest oil price.
Since oil demand tends to dovetail with economic growth, the biggest issue on the demand side is clearly that the direction of economic growth trends among the major oil consumers. The projected growth trend in the United States is especially puzzling: job creation is growing and household income is stable. Household debt levels are, however, close to the pre-2008 rates. This time, the debt is not in mortgages, but in credit cards, and automobile and other loans. At the end of the day, demand for oil is most influenced by the overall trend in the economy, which remains a very big question mark.
Brenda Shaffer is a Nonresident Senior Fellow in the Atlantic Council’s Global Energy Center.
Image: The logo of Down Jones Industrial Average stock market index listed company Exxon Mobil is seen in Encinitas, California, on April 4. Oil prices hit $50 a barrel on May 26 for the first time in seven months, then bounced below that level and settled lower on the day as investors worried robust price gains could encourage more output and add to the global glut. (Reuters/Mike Blake)