At the World Petroleum Congress being held in Madrid, the International Energy Agency (IEA) released its Medium-Term Oil Market Report. The report revealed that there is “no obvious sign” that speculators are “behind high prices.” It noted that oil inventories are “normal to low,” which would not be the case were hoarding taking place.

It also notes that oil producers are “operating close to flat out.” Therefore, a reduction in demand from increased conservation likely offers the best prospect for immediate price relief. Such demand reduction could be precipitated by the rise in crude oil prices that triggers an oil shock.

With respect to that possible development, the report observed that should oil prices remain around their current levels, the global “oil burden” (nominal oil expenditures as a share of nominal world GDP) could reach levels not seen since the 1980s. Given past experience when the oil burden reached the elevated level at which it presently stands, energy shocks have occurred. That may hold true again. The report warned, “Despite increasing energy efficiency, this situation [high oil burden] could well herald a third oil shock.”



After the 1979-80 oil shock, the oil burden declined dramatically from just over 7% of world GDP in 1980 to just under 2% of GDP in 1988. In part, demand destruction occurred on account of substantial recessions in 1980-81 and 1981-82. From there, the oil burden continued to decline with some fluctuations before bottoming out in 1998 during the Asian financial crisis. From about $35 per barrel, the price of oil plunged to $10.42 per barrel on March 31, 1986, a drop of just over 70%. Afterward, the price of oil remained generally below $20 per barrel through the rest of the decade. Oil prices briefly spiked to just above $40 per barrel in October 1990 as the likelihood increased that war would be required to liberate Kuwait from Iraq’s invasion. The spike was short-lived and oil prices settled in the upper teens and low $20 range through much of the 1990s. The Asian financial crisis saw the price of oil fall to as low as $10.72 per barrel on December 10, 1998.

The ongoing economic downturn has been much more modest to date than the early 1980s recessions. Furthermore, monetary policy, even in the face of rising inflation, is far more accommodative than it was during the late 1970s and early 1980s when central banks took on rampaging inflation. There remains at least some question whether the Fed’s currently overly accommodative monetary policy stance will lead to a situation where inflation expectations become unanchored and the monetary policy prescription to address that problem might be stronger than would otherwise be needed. However, with the biggest growth in demand for oil now coming from outside the OECD, a significant U.S. recession would not have the same impact it once did on worldwide oil consumption.

In addition, the IEA stated that growth in oil supply capacity, is likely to be “front end loaded” with the biggest capacity expansions occurring in the 2008-2010 timeframe. Afterward, oil supply capacity is forecast to increase by less than 1 million barrels per day during the 2011-2013 period. All said, the IEA’s forecast for 2012 is 2.6 million bbls/day lower than that released last year.



Barring a change in the fundamentals described above that have contributed to a demand imbalance that has driven the price of crude oil higher, market psychology will probably be a critical player in determining how far the price of oil retreats in the near-term as demand reduction, even demand destruction, takes place. Given OPEC’s reaffirmed position of avoiding price bands, its continuing references to oil stocks, and its interest in avoiding a steep decline in oil prices, the prospect that OPEC would reduce production should demand begin to fall off materially would loom large. As a result, the psychological underpinnings for the kind of steep drop in crude oil prices that occurred following the 1979-80 energy shock are unlikely to be present. Hence, a more modest near-term drop would be possible, but the price of crude oil would remain somewhat sticky whereby prices would rise more quickly than they would fall. In such an environment, a drop along the lines of that which occurred during the 1980s, which would bring the price of crude oil down to around $43 per barrel, would be extremely unlikely. Moreover, adverse geopolitical developments would still have the potential to cause significant increases in oil prices.