Short-term tightness but then long-term glut; how the heck does that happen?
We are living in the short run, and we clearly see that the crude oil markets are tight. Take a look at two datapoints: price and global inventory levels. The price of Brent crude was ~$61 at the beginning of the year, rose to ~$70 right before the Iran war started, then quickly spiked to $110. It has basically traded between $100-110 from mid-March on. Global oil inventories have been collapsing to account for the continued demand, even at these higher oil prices.
To quickly review the geopolitics here, a good portion of OPEC supply comes from the area around the Persian Gulf. The only waterway connecting the Persian Gulf oil is the Strait of Hormuz, which is currently closed. Analysts differ on the specifics, but, since the beginning of the war, roughly 15 million barrels of oil per day (MMbpd) have not reached global markets. The total daily production is about 105 MMbpd. That’s almost 15% of the global market. To put that in context, in April 2020, when the economy underwent pandemic shutdowns, global crude oil demand fell by 30%. For the full year 2020, demand was down about 10 MMbpd. Another datapoint: during the Global Financial Crisis in 2008, global oil demand was down by 1-2%. To put it succinctly, a 15% hit to global supply is a big deal.
While inventories are acting as a shock absorber currently, the shocks are beginning to wear thin. What happens when inventories can no longer provide that shock absorber? Supply and demand need to match. In a free market, that happens through the price mechanism. There have certainly been some demand-side adjustments made already, given the price reaction to date. However, with inventories continuing to drop, it has not been enough to offset the reduction in supply. Since supply is inelastic in the short run, the adjustment has to be made mostly on the demand side of the equation. Unfortunately, there is nothing short of a global recession that would reduce crude oil demand by 15%. That is the short-term risk.
In the long run, however, the world is awash in crude oil. Before the war started, crude oil prices had been falling for four years since the start of the Ukraine war. Inventories were building. There was no supply problem.
In addition, two recent developments could add to global crude supplies: the overthrow of Maduro in Venezuela and the UAE exiting OPEC. As recently as ten years ago, Venezuela was producing 2.5-3.0 MMbpd. Recently, that was closer to half a million. If Venezuela returns to the community of nations and allows Western technology in to rebuild its oil industry, it could get back to those old numbers in perhaps 5-10 years.
Secondly, the UAE exited OPEC largely because its OPEC quotas had held back its production. Before the Iran war, the UAE produced 3.5 MMbpd; its capacity is 5 MMbpd. It could literally turn that production back on tomorrow if it had the ability to export it.
I will add a third wildcard: the return of Iran to the global markets. This is clearly speculation, but let’s run out the ground ball. Given their historical numbers, Iran can likely add 1 MMbpd to global supply. Add up the three and you get an additional 4.5 MMbpd of oil production. We have plenty of oil in the long run.
How this plays out is anyone’s guess, but it wouldn’t be surprising if we get much higher oil prices even from where we are today, followed by a multi-year decline as inventories are rebuilt and production comes online. This is one risk among many that the future may hold.
We believe in building diversified portfolios to be resilient to many possible future scenarios. That doesn’t mean portfolios won’t experience volatility, but it does mean that portfolios should bounce back if and when the waters get choppy in the short term.