Is oil rally for real?

Since November 2020, oil prices have risen by 70 percent, hitting $70 per barrel in March. A united OPEC+ (comprising the 13 OPEC members plus 10 other big oil exporters), fast-recovering economies, the snowstorm in Texas, and rising geopolitical tensions in the Middle East—the recent Houthi attack on a Saudi oil exporting facility being just the latest in a series of military provocations—have pushed oil benchmarks high.

The sharp upward hike has reinforced predictions that oil prices will soar when the Covid-19 pandemic fully abates, marking the beginning of an oil supercycle, with prices potentially shooting toward or even above $100 per barrel—a level not reached since 2014. If this happens, oil would be only one of the many commodities that would benefit from unprecedented demand on the back of expansionary fiscal policies adopted by governments around the world.

Commodity supercycles are extended periods during which commodity prices are well above or below their long-run trend. They usually last much longer than business cycles, the typical up-and-down fluctuations of the economy. For a supercycle, it might take a couple of decades to get from one trough to the next.

When it comes to oil, it is possible to identify five supercycles since the beginning of the 20th century. Each has its own features, with the length of the upswing and downswing phases varying considerably from cycle to cycle.

The first three coincided with the military build-ups in the two world wars and with the reindustrialisation of Europe and Japan in the late 1950s and early 1960s. The first true supercycle started in the '70s, peaked in the early '80s, and expired in the mid-1990s. That one was triggered by OPEC's oil embargo. The latest supercycle, by contrast, started in the mid-'90s and gathered momentum with China's meteoric rise. What is unclear at the present stage is whether this cycle has ended and a new one is starting or whether the latest price surge is just a blip in an otherwise ongoing downward trajectory.

With the exception of the OPEC-driven cycle, all past supercycles were driven by fast-growing demand. The dynamic is simple. Periods of rapid industrialisation and economic development boost oil demand, pushing oil prices beyond their long-run equilibrium until new and adequate production capacity is built to meet the increased needs of the market. That new capacity comes after a delay; given the high start-up costs for new investment (particularly for traditional producers) and the long life of physical capital, firms need to be sure about the structural nature of the demand increase before they make any moves. But this delay compounds the rise in prices.

Proponents of the idea that a new oil supercycle is starting emphasise a number of forces, primarily from the demand side, that point to widening market imbalances. These include the post-pandemic economic recovery, highly accommodative fiscal policies, and more aggressive environmental policies around the world. The plans to contain the economic fallout of the pandemic are expected to keep stimulating demand during the recovery across the major economies. In particular, US President Joe Biden's $1.9 trillion rescue package targets primarily middle- and lower-income households that have a higher propensity to consume. It could, in turn, boost consumption.

Meanwhile, the green transition is gathering momentum around the world. The Green New Deal touted by Biden during his electoral campaign envisions investing $1.7 trillion (of an estimated $5.3 trillion through 2030) in projects aimed at greening the US economy. An additional $3 trillion will come from the private sector. At least in the short term, though, this fight against climate change will boost demand for the commodities (oil included) needed to build renewable energy infrastructure, batteries, and electric vehicles. Not only does the United States need to renew its aging infrastructure, but it needs to do it in a way that takes into account, for example, an ever increasing number of electric vehicles. Other countries are no different.

Following the logic of the supercycle theory, it will take time for commodity producers to catch up with rising demand, pushing oil prices higher. Most oil projects, including those taking advantage of unconventional sources such as Canada's oil sands, take three to six years after a firm's investment decision before they are up and running. Only shale oil projects in the United States can take less than one year to develop, but the life of such wells is rather limited (around 12-18 months). And the industry has suffered from years of underinvestment that was further compounded by Covid-19. Last year, around 30 percent of planned investment projects worldwide were cancelled or radically scaled back.

All this seems to point, again, to the dawn of a new supercycle with higher and higher prices in the years to come.

There is certainly some truth in the supercycle scenario, particularly when it comes to the ability of the green transition to disrupt economies (for good) even as they boost demand and investment in the short term. However, there are a number of factors that undermine the case.

First, proponents of the supercycle scenario are probably too bullish about the demand implications of Biden's fiscal plan, given that is more a relief package than a stimulus plan.

Its goal is to shore up the livelihoods of those hurt by the shutdowns and to fill the output gap generated by the pandemic, as well as to provide resources to deal with the pandemic itself. From an oil perspective, this means that these measures should, at most, bring demand back to roughly its pre-crisis levels.

Second, rising public debt due to anti-pandemic fiscal measures might reduce the scope for governments to adopt ambitious green development projects. The more the Biden administration spends now, the higher the financial and political constraints to spend for green investments in the future. European national governments might face similar constraints.

Third, the emergence of virus variants and diverging vaccination paths around the world might create a decoupling between different regions. In particular, oil-thirsty emerging economies are behind in terms of their vaccination campaigns—not just in terms of administered vaccines but also of procured doses—and this might weigh on demand going forward if it takes long for them to normalise economic activity and social life.

Supercycle predictions also overlook the structural impact of the pandemic on oil demand. Although tourist activity is likely to rebound and return to pre-crisis levels over the next few years, flexible working arrangements might drastically reduce commuting mileage for millions of workers. And Covid-19 might lead to a permanent and significant decline in business trips in favor of videoconferences as well as to the reshoring of some industrial activities in order to reduce vulnerability to shocks in global supply chains. This is oil demand that will be permanently lost.

Also on the supply side, there are a number of factors that call for cautiousness. At the moment, OPEC+ curbs have reduced oil output by around 8.7 million barrels per day. Once these frozen barrels return to the market, they will (partly or entirely) offset the positive impact of rising demand on prices. And at current prices, the temptation for OPEC+ to phase out the restrictions is very high, given the poor health of the public finances of many traditional producers.

In other words, the underlying assumptions of the supercycle thesis look stretched. The rally of recent weeks, fuelled by market enthusiasm for the vaccines and compounded by market speculation, might just be a spike in the fading supercycle that started in the mid-1990s rather than the beginning of a new one. This would mean that oil would have already passed its peak. Its gradual displacement as the key commodity powering economies around the world would, in turn, accelerate.

Edoardo Campanella is a Future World fellow at IE University's Center for the Governance of Change in Madrid and the co-author, with Marta Dassù, of Anglo Nostalgia: The Politics of Emotion in a Fractured West.

Disclaimer: This article first appeared on foreignpolicy.com, and is published by special syndication arrangement.