Column: The recession will be necessary to rebalance the oil market

LONDON, 22 Sept. (Reuters) – Spare capacity in world oil production has fallen to exceptionally low levels, contributing until very recently to intense upward pressure on prices.

Restoring spare capacity to more comfortable levels will require a downturn in the business cycle, which is why a recession or at least a major slowdown is inevitable.

In common with crude and product inventories and new, rapidly developing oil fields, underused wells and refineries act as shock absorbers in the global oil system.

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But since mid-2020, all of these sources of flexibility have eroded, leaving the market very vulnerable to shocks from unexpectedly strong consumption or any interruption in production.

U.S. oil inventories, including the strategic oil reserve, have depleted at the lowest seasonal level since 2008.


US shale producers, who have provided nearly all of the increase in world crude oil production between 2010 and 2019, are now opting to limit growth for higher profits.

As a result, unused global production capacity has shrunk and is equivalent to only 1.5% of global consumption, according to Saudi Aramco (“Remarks by CEO Amin Nasser at Schlumberger Digital Forum,” September 20).

Unless and until some of these shock absorbers are rebuilt to more comfortable levels, oil prices are likely to remain high and have an upward trend.

Based on experience, however, inventories and spare capacity will only increase when the global economy enters a period of sub-trend growth or a full-fledged recession.


Profit-maximizing firms do not intentionally invest in higher oil stocks or spare production capacity.

Conversely, oil inventories and spare capacity unintentionally increase when consumption turns out to be lower than expected because the business cycle suddenly slows down.

Large increases in crude oil and fuel inventories occurred following the recessions in 2001/02, 2008/09 and 2020 and the mid-cycle slowdowns in 1997/98 and 2014/15.

There is no counter-case where inventories have increased significantly while the business has continued to expand rapidly.

Inventories increase when and only when the business cycle unexpectedly slows down, and the same goes for production capacity.

Severe recessions leave permanent impacts on oil production and consumption and result in temporarily unused capacity later on.

The recessions of 1974, 1980, 2008 and 2020 left oil production and consumption on a permanently lower trajectory than before.

First, recessions have led to a larger and faster decline in consumption than production, leading to the accumulation of inventories and consequent spare capacity.

Over time, however, manufacturing responded more aggressively due to lower investment, while consumption rebounded as recessions eased.

As a result, inventories ran out and spare capacity was reabsorbed in the years following the recession, until prices began to rise to curb growth in consumption and encourage more investment in production.

In any case, inventories continued to run out and spare capacity continued to decline, causing significant upward pressure on prices, until the next slowdown in the economic cycle.

There is no recorded case where reserve oil production capacity has increased as the global economy has continued to grow strongly.

There is no evidence that manufacturers have ever deliberately invested in spare capacity simply to provide greater shock absorption or limit further price increases.

The spare capacity in Saudi Arabia and some other Gulf states in the 1980s, 1990s and again in the 2010s was the legacy of the economic cycle slowdowns in 1980, 1992, 1998 and 2015.


The same link between slack and economic cycle slowdowns has been present in other capital-intensive sectors such as mining.

It explains why inflationary pressures are cyclical, easing immediately after a recession when spare capacity is plentiful, then growing progressively as expansion matures and spare capacity erodes.

It also explains why it was inevitable that the US Federal Reserve and other major central banks would be forced to tighten monetary policy aggressively as the current expansion matured.

The mood of inflationary pressure stemming from the shortage of slack in energy markets and other sectors had already intensified throughout 2021, well before the Russian invasion of Ukraine in February 2022.

As many commentators have pointed out, the Federal Reserve and other central banks cannot reduce inflation by producing more barrels of oil, cubic meters of gas and megawatts of electricity.

But they can slow the economy enough to bring the growth in energy demand back into line with the trend in available production, rebuild inventories, and increase spare capacity to more comfortable levels.

Related columns:

– US diesel shortage shows economy is reaching capacity limit (Reuters, Aug 4) read more

– US oil shortages mean deeper economic slowdown will be needed (Reuters, July 28) read more

– Global diesel demand begins to slow as the economy falters (Reuters, July 8) read more

– Diesel is the inflation rate of the US economy (Reuters, February 9) read more

John Kemp is a Reuters market analyst. The views expressed are his

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Editing by David Evans

Our Standards: Thomson Reuters Trust Principles.

The views expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence and freedom from prejudice.

John Kemp

Thomson Reuters

John Kemp is a senior market analyst specializing in oil and energy systems. Prior to joining Reuters in 2008, he was a business analyst at Sempra Commodities, now part of JPMorgan, and an economic analyst at Oxford Analytica. His interests include all aspects of energy technology, history, diplomacy, derivatives markets, risk management, politics and transitions.


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