OPEC Artificial Supply Deficit Becoming Real

Analysts have been predicting a global supply-demand deficit since oil markets recovered from the 2020 pandemic collapse. This time it may finally happen but not for the reasons put forward over the last few years. Recent events in the Middle East are more likely to lead to higher oil prices than market fundamentals.

Before the October 7 Hamas attack, OPEC+ had been actively managing world oil supply and demand since early 2017. After oil prices fell below $100 in late 2022, OPEC+ reduced supply by 2 million barrels per day (mmb/d) (Figure 1). OPEC had never before cut production when oil prices were more than $90 per barrel. A few months later, Saudi Arabia and Russia cut another 1.7 mmb/d. This is real wealth transfer from consumers to producers despite OPEC’s claim that cuts are part of its plan to maintain stable markets.

Figure 1 shows several orders of price-cycling within the overall arc of oil-price increase through June 2022, decrease to May 2023, and subsequent increase. These higher-frequency cycles represent what economist James K. Galbraith calls the choke-chain effect.

“Like the choke collar in a dog, the effect does not necessarily prevent economic growth. But as the consumption of energy resources accelerates, prices rise quickly and profitability drops rapidly. This lowers investment, sows doubts about the sustainability of growth and may also trigger a (perverted) tightening of other economic levers.”

When energy supply is abundant, oil prices fall toward the variable cost of the most efficient producers. For most of the period from 2014 through 2020, U.S. shale producers set the marginal price of oil much to OPEC+’s frustration. When supply is scarce as it has been since 2020, price is not limited by the marginal barrel but increases to the level of market concern about demand destruction.

“In a world where resources have become scarce, and also financialized, the end result will not be an indefinite series of price increases. Instead, it is a cycling of both key resource prices and financial activity.”
–James K. Galbraith, The End of Normal

Price cycling and its associated price volatility create market anxiety and unwillingness to invest in new supply. Once this kind of price cycling is established, it is likely to persist until some new technology emerges—like shale in the 2010s—or an economic slump reduces demand. Some investors are betting that renewable energy is this new technology. I wouldn’t count on it.

The Russian invasion of Ukraine in 2022 created real energy scarcity and the subsequent OPEC+ production cuts have perpetuated it. Recent events in the Middle East threaten to accentuate these factors. It seems likely that prices will cycle progressively higher as Michael Tran and Helima Croft noted recently.

“There is significant asymmetric upside to near-term oil prices in the event that the Israel-Hamas war escalates into a wider-spread regional conflict…The price path to much higher levels could still be very non-linear.”

Some analysts suggest that oil prices could surge to $150 or higher. It seems improbable that prices could sustain such levels if they are in fact reached. It is more likely that an expanded Middle East conflict and rising oil prices would result in a substantial slump in the global economy and deflation of commodity prices including oil.