Reevaluating Energy Market Cycles

It’s been said that prices don’t lie. And judging from soaring gasoline prices in 2022 — which reflect soaring crude oil prices — it seems that global oil production hasn’t kept up with the economic recovery that followed the height of the pandemic when oil demand plummeted.

The question is, of course, Why?

Declines in global oil demand don’t happen frequently. As Figure 1 shows, global demand has dropped just five times over the past half-century:

• OPEC crude oil embargo of 1973-1974.

• Recessionary period of 1980-1983.

• Recession and oil price shock of the early 1990s.

• Global financial crisis of 2008-2009.

• COVID-19 pandemic in 2020.

In the latest decline, demand for oil, gasoline and diesel fell as economic activity briefly ground to a near halt during the apex of pandemic shutdowns in mid-2020. Refineries quickly reduced production capacity to keep from operating at highly unprofitable levels.

Aiming to preserve cash, oil companies drastically cut production. With producing and refining making little sense from a marginal cost standpoint, the industry largely shelved plans to build additional production facilities.

Typical Oil Industry Cycles

Historically, oil and gas producers pump more oil when oil prices rise. Consumption eventually erodes as high prices suppress demand, and increased production raises inventory levels. Producers then scale back their output.

As supply declines, inventories decline, demand eventually increases and prices follow, with producers slowly boosting output. In short, it’s a repeating cycle.

Over the last two years, demand for crude oil has rebounded slowly but hasn’t returned to pre-pandemic levels. China, for example, a top global consumer of oil, still faces pandemic-related economic weakness resulting in reduced levels of demand.

Nonetheless, as the Russia/Ukraine war intensified, global crude oil prices in May reached their highest point in 14 years, while U.S. gasoline prices hit their highest level in history. Since then, prices have moderated but remain elevated from a historical perspective.

Traditionally, oil and gas producers drill for more oil when prices surge. That means more drilling rigs are actively operating. Not surprisingly, industrywide “rig counts” tend to follow prices upward and downward.

Is It Different This Time?

So far, yes. Since their pandemic lows, rig counts haven’t kept pace with the scope of surging global oil prices. See Figure 2.

Even though demand for oil and gasoline fell quickly in 2020, it rebounded at a slower rate. At the same time, leading global economies continued trying to accelerate their transitions toward renewable energy sources.

In response, large oil and gas firms, most of which have invested in renewable energy, have shown reticence to invest new capital in traditional oil production. They increasingly consider whether their best return potential lies in migrating to renewable energy, not in maintaining facilities that may be obsolete in a few decades or sooner. (See several states’ plans, led by California, to ban sales of new gas-powered cars by 2035.)

Capital Decisions

In addition, investors have increasingly pressured oil company management teams to demonstrate fiscal discipline in recent years. Historically, when oil prices rose, oil and gas companies spent additional operating cash flow on extra drilling, boosting industrywide rig counts.

But as the pandemic has eased and prices have surged, investors in oil and gas companies have enjoyed the cash-flow benefits in the form of rising dividend payments and stock buybacks. Producers also have focused on reducing their debt. This has limited new drilling and production, helping keep prices elevated.

Finally, compensation for executive management teams in the energy sector has changed from previous cycles. More emphasis now exists on generating free cash flow, controlling operating costs, delivering strong capital returns and ensuring the health and safety of employees.

That’s a dramatic shift from past cycles when company management obtained a more significant share of its compensation from securing new fossil fuel reserves and boosting production.

The pandemic created unforeseen upheaval in the supply and demand picture for oil and gas producers. But given investors’ desires, related changes in management compensation and the trend toward renewable energy, the industry has altered its traditional response to disruptions in supply and demand.

Within that current framework, oil production won’t increase as significantly as it once did when prices surged. Higher prices probably will stay higher longer as a result.