The Oil Market’s Search for a New Equilibrium

Global oil demand is approximately 100 million barrels per day (bpd), and the rate of annual demand growth is equivalent to the growth rate of real GDP. The oil market is globally traded, despite various regional grades, and supply-demand imbalances in one area of the world tend to disrupt the entire market. Oil remains in long-term equilibrium, but short-term imbalances often persist. When equilibrium is disrupted, market forces typically respond quickly to reassert balance. For all commodities markets, including oil, price volatility reflects the process to discover new equilibria.

Short-term imbalances are often the outcome of natural disasters (e.g., storms) or geo-political conflict. Supply shortages and demand surges generate rising prices. The market response to restore equilibrium involves a combination of increased production and reduced consumption (i.e., conservation measures). Conversely, excess supply and waning demand are associated with declining prices. The market response to restore equilibrium is often an immediate cut to production.

Supply responses are asymmetric. It is much easier to simply shut off a well than to set up a rig and boost production. With respect to demand, food and fuel price increases have the net effect of a consumption tax. Consumers are generally unable to significantly reduce fuel consumption when prices rise. On the other hand, fuel consumption does not increase simply because prices are lower. Volumes do not vary significantly except during recessions. Instead, declining fuel costs create a windfall that typically leads to increased spending on discretionary items.

Generally, consumers respond quicker to high food and fuel costs, which tend to crowd out spending on other items. During periods of heightened volatility, therefore, market adjustments are temporally asymmetric – i.e., production increases are slower than production cuts; consumer spending decreases faster than it increases (i.e., relative elasticity).

The surge in oil prices during recovery from the Great Financial Crisis attracted massive investment in domestic onshore production (i.e., shale). Energy was one of the few sectors that experienced job growth and recovering credit markets facilitated development of basins that had been considered unproductive. Technological breakthroughs such as horizontal drilling contributed to large production increases. In addition, there were substantial infrastructure investments in transmission and development.

Eventually, excessive investment led to a supply glut. Crude oil prices fell to an equilibrium level below the “break-even” points for many of the basins developed from 2008 – 2012. The average “break-even” price for many onshore basins exceeds $40 per BOE (i.e., barrel of oil equivalent), requiring a minimum price of $60 – 70 per BOE to earn a positive return on capital. From 2015 – 2021, the average price per barrel of crude oil was $53. The number of rigs in operation collapsed during that period, and valuations of upstream energy companies (i.e., oil and gas production and development) entered a multi-year correction.

Initially, the global pandemic was a demand shock. The willingness to consume presumably did not wane, which is atypical when confronted with extreme uncertainty, but restrictions and lockdowns severely curtailed the ability to consume. Crude oil is utilized primarily for transportation, and transportation is integral to global trade. Because of uncoordinated policy responses to new variants of COVID, demand recovery has been gradual and inconsistent. Recent high frequency data, such as TSA enplanements, indicate economic activity in the United States has nearly recovered to pre-pandemic levels. In addition, as more workers resume daily commutes in their RTO (i.e., return to the office), demand for crude oil should continue to grow.

During the Cold War, countries formed coalitions and multi-national alliances to avert military conflict. Many alliances were formed under the auspices of trade agreements. The premise was nations would avoid hostilities with trade partners. In terms of direct conflict, that premise has held. However, frequent “proxy” wars reflect methods of engaging in indirect conflict. In response to proxy conflicts, developed nations favored countermeasures such as economic sanctions to impose hardship on aggressor nations. Economic sanctions primarily restrict demand for an aggressor nation’s exports. For a commodity market such as oil, however, sanctions disrupt the global supply-demand balance, at least temporarily.

Depending on one’s perspective, Russia’s invasion of Ukraine is a proxy war. Insofar as Western nations are concerned, the invasion terminated a multi-decade diplomatic effort to integrate Russia into the global community. Developed nation responses to the invasion were swift, severe, and for the most part, coordinated. They were also typical. Through imposition of sanctions, Western governments effectively restricted demand for Russian exports, similar to the response to Russia’s invasion of Crimea in 2014.

Sanctions, in this case, have had a deleterious collateral impact because several key nations in Western Europe had become too dependent on Russia’s energy exports. To comply with strict effective dates of sanctions, certain economies are now scrambling to secure alternative energy supplies. For some, the timetable for a complete embargo, especially for Russia’s natural gas, will likely prove problematic.

Russia’s invasion of Ukraine exposed the fact that Germany, in particular, had become too dependent on Russian oil and natural gas. Over time, market responses will correct regional imbalances as both global and domestic production should increase gradually. However, there are daunting obstacles to near term resolution of supply shortages, most notably associated with logistics (i.e., transmission and distribution). This suggests some Western European nations will depend on Russian energy exports for the foreseeable future.

Under an increasingly probable scenario in which Western nations eventually embargo all Russian energy exports on a permanent basis, global production must significantly increase to offset this unavailable supply. Western European nations will likely engage alternative suppliers before Russian oil/gas production is no longer available for their consumption. These adjustments could recalibrate supply-demand dynamics and create a market for oil that is “less than global.” A discounted price for Russian oil could become a permanent aspect of the market, and governments could use moral suasion and sanctions to further discourage consumption despite lower relative prices. To the extent Western nations withhold demand for Russian energy, oil/gas supply agreements will require renegotiation, suggesting further price volatility. New supply arrangements will also require massive energy infrastructure – e.g., Liquefied Natural Gas (LNG) facilities.

There are near- and long-term trade-offs associated with a transition from an integrated, global oil market to a market that is bifurcated – i.e., Russia and some of its trade partners operate in an isolated manner. In the near term, logistical challenges to securing alternative supply sources and pressures to satisfy demand suggest a focus of capital investment on expanding capacity.

For the long term, the conflict could accelerate investment in renewables. However, given capacity constraints, current projections for transition to renewables are likely unrealistic. In addition, the conflict will likely first encourage investments in spare oil and gas capacity. Therefore, over the next few years, we anticipate large investments in energy infrastructure as well as supply chain diversification. Absent a deep, global recession, demand for crude oil should increase substantially over the next few years.