Why is oil so cheap? Prices might seem high to consumers – they have nearly doubled since December. But with 10 per cent of the world’s oil exports still cut off and no obvious progress in peace talks, Friday’s close of $101 for Brent crude looks amazingly calm, or complacent.
Oil prices have exceeded $100 per barrel, accounting for inflation, on five occasions: during the 1978-81 period of the Iranian revolution and the outbreak of the Iran-Iraq war; at the end of the Chinese-driven commodities boom in 2008; during the Libyan revolution and sanctions on Iran in 2011-14; in 2022, after the Russia's full invasion of Ukraine; and now in the current war.
The late 1970s is the closest comparison to the current situation. There was real physical damage to facilities. The other Opec countries, rather than offsetting the crisis, cut back from 1980 onwards to preserve high prices. World production fell by about 10 per cent between 1979 and 1981, a magnitude similar to today’s cut-off, though unfolding more slowly.
Oil prices just before the revolution in 1978 averaged at the present-day inflation-corrected equivalent of $67, and were close to those levels shortly before the current Gulf conflict. They more than doubled in 1979, were even higher in 1980 at $140 per barrel, and fell back only gradually in 1981 and 1982.
In this year’s war, Brent crude averaged $101 in March, $118 in April and slightly less than $106 so far this month.
But economics would suggest that prices could and should go much higher in this conflict than in 1979-1981. Oil accounts for a much smaller share of the world economy due to improved efficiency, alternative energy sources and a shift towards less energy-intensive activities. Counter-intuitively, prices could rise much higher today before they become a serious drag on global growth. Yet, so far, they have been remarkably restrained.
There are five possible explanations, not mutually exclusive.
Futures vs physical
First, futures prices traded on exchanges do not properly represent the real, physical market for oil. In mid-April, Dated Brent – based on physical crude – was at $120 per barrel while Brent futures were trading around $100.
However, when each monthly contract expires, the settlement price is set by reference to physical oil trades. This month, the gap has mostly closed and physical prices have fallen towards futures rather than futures rising. Frequent releases of positive news about peace talks – often then disproved promptly – and “jawboning” of prices down by US President Donald Trump and other officials in Washington make it risky for traders to take long positions.
Indeed, prices for refined oil products are signalling more clearly than crude. US wholesale petrol prices have more than doubled since the start of the year, while crude is up only 67 per cent. Prices for distillates – diesel and jet fuel – have reached scary heights in some markets. But even for these fuels, prices have remained marooned since early March.
Peace premium
Second, the market believes the war will be over soon and the Strait of Hormuz will be reopened to normal traffic. In this case, it would be OK to run down inventories, in the expectation that they can be restocked shortly.
But negotiations seem to be going in circles, only a few tankers are creeping through the strait, and the US blockade of Iran's shipments has further reduced oil getting to market. Further afield, Ukraine keeps successfully exploding Russian refineries and pumping stations.
Indeed, as long as oil prices remain moderate, there is limited pressure on the White House to agree to a deal. Conversely, Tehran will want to drag out the crisis to inflict real economic pain and deter future attacks, whether by Mr Trump or any future president.
Even once the strait reopens, it will take months for production and shipping to return to normal.
Leaner inventories
Third, perhaps the oil system can function effectively with much lower levels of inventories than thought, because of AI-enhanced enablers, or rising electric vehicle use in China.
This theory is going to be tested soon. US distillate stocks are already at their lowest since 2005. Japanese and Indian inventories are at their seasonal lowest for at least 10 years. European jet fuel is also at a post-Covid nadir.
In JP Morgan’s view, global stocks, which began the war at an elevated level of about 8.3 billion barrels, will hit a stressful 7.6 billion by June. If there is no resolution, by September they will fall to 6.8 billion, a minimum operational level.
Demand destruction
Fourth, it could be that the global economy can destroy about 10 million bpd of global oil demand without, so far, suffering serious consequences. Serious losses so far have been confined to middle-income Asian countries, such as the Philippines, Vietnam and Pakistan, which has limited global impact.
Demand destruction seems unlikely to be a complete explanation. It is part of the story – probably up to 3 to 4 million bpd of consumption has been cut, mostly in Asia, from airlines eliminating flights and petrochemical plants cutting operations. Those reductions cause real economic pain, which will eventually show up, even in the West, in the form of lower tourism and higher prices for plastic goods.
Yet the last times oil prices were above $100, global oil consumption grew robustly in 2009-14, and dramatically in 2022-23, aided by the post-Covid rebound. So why would prices barely above $100 inflict demand destruction greater than that of the pandemic lockdowns today?
Temporary pause
Fifth, the recent drop in prices is a temporary pause, resulting from special factors. China has cut back on oil imports, probably because it is drawing from massive underground inventories built up last year. The International Energy Agency countries’ release of 400 million barrels of strategic reserves helps supply but it cannot be sustained indefinitely.
US crude exports have soared – though this represents a transfer of the pain from the rest of the world to the American consumer. And, unlike medium-density Middle Eastern grades, light American shale oil is not well-suited to making the diesel and jet fuel that the market most needs.
Asian refiners have temporarily held back on buying crude inputs, hoping for a resumption of Gulf supplies and not wanting to be caught with expensive cargoes.
The global economy had better hope that painless demand destruction, flexible inventories and well-founded hopes for a rapid end to the blockade explain the lack of alarm. Otherwise, history tells us consumers will soon be asking the more familiar question” “Why are oil prices so high?”
