Unused capacity in global oil production has fallen to exceptionally low levels, contributing to the intense upward pressure on prices until very recently.
Restoring spare capacity to more comfortable levels will require a business-cycle downturn, which is why a recession or at least a serious slowdown is inevitable.
In common with inventories of crude and products, and new oilfields with rapid development times, under-utilised oil wells and refineries act as shock absorbers in the global petroleum system.
But since the middle of 2020, all these sources of flexibility have eroded, leaving the market much vulnerable to shocks arising from unexpectedly strong consumption or any disruption to production.
U.S. petroleum inventories including the strategic petroleum reserve have depleted to the lowest seasonal level since 2008.
U.S. shale producers, who supplied almost all the increase in global crude production between 2010 to 2019, are now opting to limit growth to enjoy higher profits.
As a result, spare global production capacity has shrunk and is equivalent to just 1.5% of global consumption, according to Saudi Aramco.
Unless and until some of these shock absorbers are rebuilt to more comfortable levels, oil prices are likely to remain high and on an upward trend.
Based on experience, however, inventories and spare capacity will only rise when the global economy enters a period of sub-trend growth or an outright recession.
RECESSIONS AS RESETS
Profit-maximizing enterprises do not intentionally invest in higher oil inventories or spare production capacity.
Instead, oil stocks and spare capacity increase unintentionally when consumption proves lower than anticipated because the business cycle suddenly slows.
Large increases in stocks of crude and fuels occurred as a result of recessions in 2001/02, 2008/09 and 2020, and mid-cycle slowdowns in 1997/98 and 2014/15.
There is no counter-case where inventories have risen significantly while business activity has continued expanding rapidly.
Inventories rise when and only when the business cycle slows unexpectedly, and the same is true about production capacity.
Severe recessions leave permanent impacts on oil production and consumption and temporarily result in spare capacity in their aftermath.
Recessions in 1974, 1980, 2008 and 2020 all left oil production and consumption on a permanently lower trajectory than before.
In the first instance, the recessions induced a larger and faster fall in consumption than production, causing inventories to accumulate and resulting spare capacity.
Over time, however, production responded more aggressively as a result of lower investment, while consumption rebounded as the recessions faded.
As a result, inventories have depleted and spare capacity has been reabsorbed in the years following a recession, until prices started rising to restrain consumption growth and encourage more investment in production.
In each case, inventories continued to deplete and spare capacity continued to fall, resulting in consistent upward pressure on prices, until the next business cycle slowdown occurred.
There is no recorded instance where spare oil production capacity rose when the global economy continued to grow strongly.
There is no evidence producers have ever deliberately invested in spare capacity simply to provide more shock absorption or limit further price increases.
Spare capacity in Saudi Arabia and some other Gulf states in the 1980s, 1990s and again in the 2010s was the legacy of business cycle slowdowns in 1980, 1992, 1998 and 2015.
The same link between spare capacity and business cycle slowdowns has been present in other capital intensive industries such as mining.
It explains why inflationary pressures are cyclical, subdued in the immediate aftermath of a recession, when spare capacity is plentiful, then building progressively as the expansion matures and spare capacity erodes.
It also explains why it was inevitable the U.S. Federal Reserve and other major central banks would be forced to tighten monetary policy aggressively as the current expansion became more mature.
Inflationary pressure stemming from shortages of spare capacity energy markets and other industries had already been intensifying 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 metres of gas, and megawatts of electricity.
But they can slow the economy enough to bring energy demand growth back into line with the trend in available production, rebuild inventories, and increase spare capacity to more comfortable levels.
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