LONDON, Sept 22 (Reuters) – Unused capacity in global oil production has fallen to exceptionally low levels, contributing to intense upward pressure on prices until very recently.
Restoring idle capacity to more comfortable levels will require a slowing of the business cycle, which is why a recession or at least a serious downturn is inevitable.
Like crude and product inventories and rapidly developing new oil fields, underutilized oil wells and refineries act as shock absorbers in the global oil system.
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But since mid-2020, all of these sources of flexibility have eroded, leaving the market highly vulnerable to shocks from unexpectedly strong consumption or any disruption in production.
US oil inventories, including the Strategic Petroleum Reserve, have depleted to the lowest seasonal level since 2008 (https://tmsnrt.rs/3qWJqE3).
U.S. shale producers, which provided nearly all of the increase in global crude production between 2010 and 2019, are now opting to limit growth to enjoy higher profits.
As a result, unused global generation capacity has shrunk and equates to just 1.5% of global consumption, according to Saudi Aramco (“CEO Amin Nasser’s Remarks to Schlumberger Digital Forum,” September 20).
Unless and until some of these buffers are rebuilt to more comfortable levels, oil prices will likely remain high and on an upward trend.
Experience shows, however, that inventories and spare capacity will only increase when the global economy enters a period of below-trend growth or outright recession.
RECESSIONS AS RESETS
Profit-maximizing firms do not intentionally invest in higher oil inventories or spare production capacity.
Instead, oil inventories and spare capacity rise unintentionally when consumption turns out to be weaker than expected due to a sudden downturn in the business cycle.
Sharp increases in crude oil and motor fuel inventories occurred following the recessions of 2001/02, 2008/09 and 2020, and mid-cycle downturns in 1997/98 and 2014/15.
There is no counter-case where inventory has increased significantly while business activity has continued to grow rapidly.
Inventories rise when and only when the business cycle unexpectedly slows, and so does production capacity.
Severe recessions leave permanent impacts on oil production and consumption and temporarily result in unused capacity.
The recessions of 1974, 1980, 2008, and 2020 all left oil production and consumption on a sustainably weaker path than before.
In the first case, recessions have induced a greater and faster drop in consumption than in production, resulting in an accumulation of stocks and therefore unused capacity.
Over time, however, production reacted more aggressively due to lower investment, while consumption rebounded as recessions subsided.
As a result, inventories were depleted and spare capacity was reabsorbed in the years following a recession, until prices began to rise to curb consumption growth and encourage more investment in generation. .
In each case, inventories continued to deplete and spare capacity continued to fall, leading to constant upward pressure on prices, until the next downturn in the economic cycle.
There are no recorded instances of spare oil production capacity increasing as the global economy continued to grow strongly.
There is no evidence that producers ever deliberately invested in spare capacity simply to absorb more shocks or limit further price increases.
Unused capacity in Saudi Arabia and some other Gulf states in the 1980s, 1990s and again in the 2010s was the legacy of business cycle downturns in 1980, 1992, 1998 and 2015.
The same link between idle capacity and business cycle downturns has been present in other capital-intensive industries such as mining.
This explains why inflationary pressures are cyclical, easing immediately after a recession when spare capacity is plentiful, then gradually strengthening as the expansion matures and the spare capacity erodes.
It also explains why it was inevitable that the US Federal Reserve and other major central banks would be forced to tighten monetary policy aggressively as the current expansion matured.
Inflationary pressure resulting from the shortage of spare capacity in energy markets and other industries had already intensified throughout 2021, well before Russia’s invasion of Ukraine in February 2022.
As many commentators have pointed out, the Federal Reserve and other central banks cannot reduce inflation by producing more barrels of oil, cubic meters of gas, and megawatts of electricity.
But they can slow the economy enough to bring energy demand growth back in line with the trend in available generation, rebuild inventories and increase unused capacity to more comfortable levels.
– US diesel shortage shows economy reaching capacity limit (Reuters, August 4) Read more
– Low U.S. oil inventories imply deeper economic slowdown will be needed (Reuters, July 28) read more
– Global diesel demand begins to slow as economy falters (Reuters, July 8) read more
– Diesel is the inflation canary of the US economy (Reuters, February 9) read more
John Kemp is a market analyst at Reuters. Opinions expressed are his own.
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Editing by David Evans
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