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Column: Oil price spikes and permanent consumption losses

LONDON (Reuters) - Promises by U.S. shale producers to pursue a more restrictive approach to capital investment and production seem to have emboldened Saudi Arabia and its allies in OPEC+ to test the room for higher oil prices.

A drilling rig operates in the Permian Basin oil and natural gas production area in Lea County, New Mexico, U.S., February 10, 2019. Picture taken February 10, 2019. REUTERS/Nick Oxford

If shale firms respond to higher prices and revenues by returning capital to lenders and investors, rather than increasing output, there may be an opportunity for OPEC+ to let prices rise without losing market share.

“Drill, baby, drill is gone for ever. Shale companies are now more focused on dividends,” the Saudi energy minister said in an interview on March 4.

“It’s the shale companies which are themselves changing. They have had their fair share of adventure and now they are listening to the call of their shareholders.”

The kingdom’s interest in testing support for higher prices comes when many investors are expecting a strong upward cycle, or even supercycle, in oil and other commodity prices.

Strong economic growth after the COVID-19 pandemic, coupled with expansionary fiscal and monetary policies, is expected to accelerate consumption growth for oil and other commodities.

At the same time, production of oil and other commodities will be constrained by lack of investment during the price slump in 2020 and early 2021 as well as the newfound enthusiasm for “capital discipline”.

In the case of oil, some analysts are forecasting one last supercycle over the next few years before widespread deployment of electric vehicles in the late 2020s and through the 2030s starts to hit consumption.

Bond investors, too, are anticipating a period of above-average inflation, if not a commodity supercycle, as governments and central banks try to reverse employment and income losses stemming from the epidemic.

Yields for U.S. Treasury Inflation-Protected Securities imply traders expect an average all-items U.S. inflation rate of about 2.2% over the next decade.

Expected 10-year inflation rates peaked at 2.25-2.5% during the 2007/08 commodity supercycle and a similar level during the period of high oil prices from 2011 through 2014.

By comparison, realised consumer price inflation in the United States has averaged about 1.75% per year over the past decade.

PAST SUPERCYCLES

The cyclical upswing in oil prices raises several questions. Will it continue? Will it become part of a supercycle? And how will consumers and policymakers respond?

Over the past five decades, there have been three long-lasting spikes in oil prices – in 1973/74, 1979/80 and 2007/08 – with all of them sufficiently significant to be termed “oil shocks”.

Each shock also coincided with a severe business cycle downturn, though the direction of causality remains fiercely disputed by economists.

In each case, there was a permanent loss of consumption as a result of the accompanying recessions, as well as increased energy efficiency and a switch to cheaper sources of energy.

Each shock moved global consumption to a new, lower trajectory, from where it never recovered to the pre-shock path.

In the five years from 1974 to 1978, global consumption was reduced by about 22 billion barrels from the pre-1973 path.

Five-year consumption losses after the 1979/80 and 2007/08 price shocks amounted to 21 billion and 9 billion barrels respectively.

If oil consumption had continued growing at its pre-1973 trend, consumption would have reached 80.4 million barrels per day (bpd) by 1978.

Instead, actual consumption in 1978 was just 62.9 million bpd and did not reach 80.4 million bpd until 2004.

Massive consumption losses as a result of these shocks, especially in the 1970s, are the main reason oil resources did not run out in the manner predicted by peak oil advocates during the 1960s and 1970s.

PERMANENT LOSS

Supercycles leave a permanent impact on oil consumption still evident decades later; something like a permanent fossil record.

Not every rise in prices, however, is a supercycle, and not every period of high prices results in the permanent loss of consumption.

The period of very high real prices between 2011 and the middle of 2014 does not appear to have had any significant impact on consumption growth. Instead, its main impact was on production, where high prices encouraged and financed the first U.S. shale oil boom.

OPEC+ seems to be betting that it is safe to push prices somewhat higher because U.S. shale producers will leave output largely unchanged and a modest further price rise will have no impact on consumption.

THE NEXT CYCLE

On the production side, shale oil producers have pledged spending and output restraint. But over the past decade U.S. output has regularly increased whenever Brent is above $55 or $60 a barrel with a delay of up to a year.

It would seem OPEC+ expects the production response to be much stickier this time, owing to the shale producers’ proclaimed capital and output discipline.

On the consumption side, there has been no visible evidence of significant demand losses when prices have remained below $100.

But the next price cycle will be the first when there is a viable technical alternative to gasoline engines in light vehicles in the form of electric cars.

So the consumption response could be less sticky than before, especially if prices rise significantly and stay there for an extended period.

Once consumption has been lost as a result of a supercycle, it is likely to be lost for ever.

POLICY RESPONSES

Price spikes and supercycles have some of their largest and most long-lasting impacts on consumption via their impact on government policies, which are much stickier and harder to reverse.

In response to the oil shocks of the 1970s, government policies encouraged the phasing out of oil for electricity generation and space heating in favour of coal and nuclear power.

Governments in oil-importing countries also employed vehicle taxes to promote smaller, less powerful and more fuel-efficient cars.

In response to the oil shock of 2005-2008, government policies encouraged the substitution of biofuels for oil and renewed pressure for vehicle fuel economy.

More recently, in 2018 and 2019, the U.S. government, led by President Donald Trump, pressured Saudi Arabia to increase output and cool the oil market whenever Brent prices climbed above $70 a barrel and especially above $75.

It is uncertain whether a similar increase in oil prices in 2021 and 2022 under U.S. President Joe Biden would result in similar diplomatic pressure on Saudi Arabia.

Unlike individual consumer responses, the lingering effects of government conservation policies tend to reduce consumption even when oil prices subsequently fall.

If prices spike over the next few years, governments are likely to respond by mandating faster deployment of electric vehicles and other oil conservation measures, ensuring consumption losses are permanent.

John Kemp is a Reuters market analyst. The views expressed are his own.

Related columns:

- Rising oil prices put demand destruction back on the agenda (Reuters, May 2, 2018)

- Drilling for more oil in your fuel tank (Reuters, March 12, 2013)

- Oil data show nascent signs of demand destruction (Reuters, May 4, 2011)

Editing by David Goodman

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