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The diminished economic power of oil

13 February 2020 | Markets and Economy

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The power of crude oil isn't what it used to be. And a world less dependent on Middle Eastern oil could have positive implications for broadly diversified investors, not to mention the global economy.

Current oil prices seem modest compared with the $100 per barrel that crude regularly commanded between 2011 and 2014, let alone its $140-plus 2008 peak.  But the story of crude's smaller economic role is bigger than that. Absent dramatic events—such as a long closure of the Strait of Hormuz, through which roughly 20% of the world's crude supply passes each day—Vanguard experts believe that increased supply and reduced growth in demand could effectively cap prices not far from today's levels.

Oil price spikes are "likely to be modest and of short duration" for the foreseeable future, said Maria Colangelo, a senior taxable bond analyst in Vanguard's Fixed Income Group who has covered the energy sector for two decades.

An effective limit on the price of oil would help keep both the broad rate of inflation and nominal interest rates well-contained; this should benefit broadly diversified stock and bond investors, as well as the global economy.

 

How ample supply may help cap oil prices

Geopolitical tensions appear to be on the rise, but their impact on the price of oil is likely to be muted. Ms. Colangelo and Jonathan Lemco, a senior strategist in Vanguard's Investment Strategy Group, cited a trio of supply-related reasons why the price of crude oil should remain modest:

  • Global crude oil inventories are relatively high, and there is meaningful untapped capacity. Oil supplies held by members of the developed-nation Organisation for Economic Co-operation and Development (OECD) exceed their five-year historical average, and we estimate that spare production capacity in Saudi Arabia stands at roughly 3 million barrels per day. 
  • The volume of supply outside the Organization of the Petroleum Exporting Countries (OPEC) has increased, and Saudi Arabia is no longer the only large "swing producer." Russia and the United States have increased their shares of global oil production. In terms of U.S. shale oil alone, production grew 62% in less than five years—from 5.3 million barrels per day in 2015 to 8.6 million in 2019.  The abundance of shale oil has made the U.S. a swing producer—a country with ample productive wells that can raise output to take advantage of price increases—rivaling, if not supplanting, Saudi Arabia in that role.
  • In a fundamental shift for global oil markets, the U.S. has become a net exporter of oil. The shale oil revolution has meaningfully added to global oil supplies and limited prices, thanks to lower break-even costs and shorter timeframes for bringing shale oil production online relative to offshore oil. Although U.S. shale oil production costs vary widely, the business generally is profitable if market prices meet or exceed approximately $45 per barrel.  In contrast, offshore producers typically need a price of roughly $55 or more to profit.  Another advantage for U.S. shale oil is that wells can start producing after three or four months of development work. Offshore oil fields take three to six years to develop.

Brazil and Norway also expect to provide significant new sources of crude oil during the first half of 2020. In an attempt to offset at least some of the weight on prices caused by excess supply and softening demand, OPEC is operating under tight production limits; however, Ms. Colangelo and Mr. Lemco do not expect this to spur meaningful price increases.

 

Surging U.S. production adds to global oil supplies

U.S. production, imports, and exports, millions of barrels per day

Two lines showing imports and exports of U.S. crude oil and petroleum products, overlaid on a mountain chart showing U.S. field production of crude oil, all for the period January 1973 through October 2019. U.S. oil imports nearly quadrupled between early 1985 and the middle of 2006. But since peaking at nearly 14.7 million of barrels per day in the middle of 2006, U.S. oil imports have declined more than 40 percent, to about 8.6 million barrels per day. The decline in U.S. oil imports has been enabled by a rise of nearly 150 percent over the same period in the production of U.S. crude oil. The U.S. now produces more than 12.5 million of barrels of oil daily. Finally, U.S. exports of crude oil and petroleum products have surged more than seven-fold since the middle of 2006, to nearly 9 million barrels daily.

Data are from January 1973 through October 2019.
Source: U.S. Energy Information Administration.

 

How slowing demand may help cap oil prices

There are also demand-related reasons to believe that any oil price spikes are apt to be modest and short-lived. Global demand for oil has been slowing and is now trending below its five-year historical average annual growth rate of 1.3 million–1.4 million barrels per day1.

"Historically, transportation fuels have driven growth in the demand for oil," Ms. Colangelo said. "But a moderation in global economic growth, coupled with the slow secular shift toward electric vehicles and other substitutes, is likely to continue to limit growth in the demand for oil relative to its historical growth rate."

(For more on Vanguard's expectations for the broad economy, see Vanguard Economic and Market Outlook for 2020: The New Age of Uncertainty.)

There are also signs of rising energy efficiency in much of the world. (See, for example, the below chart of UK energy intensity by sector. Note that falling energy intensity implies rising energy efficiency.) Increases in efficiency can slow the growth in demand for energy, including crude oil.

 

UK energy efficiency generally improving

Energy intensity (units of energy per unit of economic output) by sector

Sets of bars showing units of energy per unit of economic output across four segments of the UK economy: residential, manufacturing, services, and car and light trucks, each for calendar years 2010 through 2017. In each economic segment, the amount of energy consumed per unit of gross domestic product declined over that horizon. The declines in so-called energy intensity represent improvements in energy efficiency, and those improvements were relatively steady in most cases, though they did not occur every year.

Source: International Energy Agency.

 

Oil shocks and caveats

An effective cap on the price of oil could help contain inflation and nominal interest rates, which would likely benefit broadly diversified investors. However, our expectation that oil price spikes are unlikely to get out of hand for the foreseeable future presupposes that long-term disruptions will be avoided. Over the last 50 years, Ms. Colangelo noted, conflicts in the Middle East have at times led to a doubling of crude prices and triggered recessions. One key example is the "second oil crisis" of 1979–1980, ignited by the Iranian revolution, followed by the outbreak of the Iran-Iraq war. A second is the 1990 invasion of Kuwait by Iraq. The ensuing price spike lasted only several months, but it took several years for the affected countries to return to full output.

Our sanguine outlook for crude oil prices could change in the event of war, or if tanker traffic were meaningfully curtailed in the Strait of Hormuz.

It's also true that major dislocations could rack smaller economies that are more dependent on oil imports or exports.

"History teaches us that emerging markets whose revenues depend on one commodity, usually petroleum, are particularly vulnerable to economic strife when oil prices falter," Mr. Lemco noted. "The lesson for investors is to remain diversified. Investments in emerging markets help provide global diversification, but it's important to diversify across emerging markets, too, and not focus on just a narrow group, such as oil producers."

 

1 Source: Vanguard estimate, based on data from the U.S. Energy Information Administration.

 

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