[Lee Jong-woo's Economic Reading] Oil Price Crash, The Unfinished Fourth Cycle

Significant Impact from COVID-19 Demand Drop... Also Due to Entering Structural Decline Phase
Once Major Downtrend Starts, Decline Lasts 15 to 21 Years
Oil and Stock Prices Moved Differently but Likely to Continue Parallel Trends for Now

Oil prices have struggled to stabilize. This is understandable, considering that last month, the price of West Texas Intermediate (WTI) crude oil once plunged to -$37.6. Since oil was being sold by paying money rather than being bought, it naturally took time for the market to interpret and adapt to this situation. The market attributes the decline in oil prices primarily to reduced demand caused by the novel coronavirus disease (COVID-19). While this is an important reason, it is not the whole story. The structural decline phase that oil prices have entered must also be taken into account.

Since 1894, oil prices have experienced four major cycles. The first began in 1894, peaked in 1917, and ended during the Great Depression in 1932. The second peaked in 1951 and declined until 1971. The third peaked in 1980 and endured about 20 years of weakness. The current, fourth cycle saw oil prices peak around 2010?2011 and continue to decline since then. As seen in the previous three cycles, once a major downtrend begins, oil prices fall for 15 to 21 years; we are currently in that phase. Given the weak foundation of the oil market, it is believed that even without the COVID-19 outbreak, oil prices would have remained at low levels.

The reason oil prices have such long cycles is due to supply rigidity. The mining sector, including oil, requires over 20 years from initial capital investment to economically viable extraction. Even when this period is minimized, it does not fall below 15 years. Applying this fact to the current situation leads to the conclusion that it will be difficult for oil supply to escape oversupply anytime soon. If oil field development began in the mid-2000s when prices were above $50 per barrel, the developed oil should now be entering the market in earnest. If the main investment period was between 2008 and 2011 when prices exceeded $100, the problem is even more severe. Oil prices plunged before the full-scale supply even began.

Looking at the past few years reveals another perspective. In the last 6 to 7 years, international oil prices have undergone three reversals. The first reversal occurred between October and December 2014. Oil prices, which were around $100 per barrel, suddenly dropped to the high $40s. This decline was led by Saudi Arabia. Saudi Arabia judged that high oil prices would increase U.S. shale oil production and promote alternative energy development, ultimately reducing oil demand. Therefore, before oversupply became entrenched, they decided to change the structure and led production increases, driving prices down.

The second reversal happened at the end of 2017. OPEC+ (the Organization of the Petroleum Exporting Countries (OPEC) members plus non-OPEC countries including Russia) raised international oil prices back above $60 through production cuts. This price level was maintained for about two years, leading to a cooperative phase where many oil-producing countries earned reasonable profits. Despite international cooperation, dissatisfaction grew within OPEC+. Producers felt that while they sacrificed to raise prices, the benefits were being reaped by U.S. shale companies that did not participate in the cuts. Since this meant sacrificing to nurture future competitors, opposition was inevitable. Ultimately, the decline in oil prices was only a matter of time.

The third reversal occurred in March this year. The fragile balance in the oil market was broken when Russia refused to cut production, causing prices to plummet. The current imbalance in the oil market is not solely due to demand reduction from COVID-19. More importantly, supply has significantly increased over a long period due to various factors. With supply overwhelming demand, the adverse effect of COVID-19 caused prices to fall rapidly.

The oil supply-demand imbalance is expected to continue for some time. Goldman Sachs estimated in March that China's oil consumption decreased by nearly 3 million barrels per day, about 20% of usual demand. If the major seven countries, including the U.S., reduced demand by the same proportion, the total would be 6 million barrels. Research institutions suggest that considering the full-scale spread of COVID-19 from April, global oil demand may have decreased by up to 30 million barrels. If this figure is accurate, the 10 million barrel production cut agreed upon last month is of little significance. Since supply far exceeds demand, partial improvements cannot prevent price declines.

What will happen to oil prices going forward? It is difficult to predict accurately because price volatility is too severe to secure the stability needed for forecasting. Based on past cases, it is likely that prices will remain in the $20 range for a considerable time. Unlike stocks, commodities have actual demand and supply. Therefore, when supply and demand are out of balance, prices fluctuate sharply, but when balanced, the established price tends to persist for a long time. The period from 1984 to 1999 was such a case, where oil prices stayed in the $10 range for 15 years. This was due to overproduction created during the previous two oil shocks, which prevented price increases. Considering the recent severe oversupply of oil, the equilibrium price this time is unlikely to differ much from the current level, which is probably in the $20 range.

When oil prices fall, the cost for companies to produce goods decreases. For countries like South Korea that rely on oil imports, this effect is even greater. The problem arises not when prices fall gradually but when they plunge sharply. A sharp drop in oil prices reflects severe global economic recession and is not beneficial to the economy.

The increased possibility of deflation due to falling oil prices must also be considered. Since 2010, oil prices and expected inflation have shown a strong correlation. Because oil is a representative commodity of raw materials, it significantly influences inflation expectations. When inflation expectations decline, companies become reluctant to invest. In a situation where product prices continuously fall, investment leads to losses.

Since 2011, oil prices and stock prices have moved in opposite directions. Despite falling oil prices, stock markets in developed countries have risen, driven by low interest rates and liquidity supply. Even as the economy worsened and oil prices dropped, stock prices rose due to liquidity. Now, the period of oil prices and stock prices moving separately is coming to an end. For the foreseeable future, low oil prices and sluggish stock prices are expected to continue together.

This content was produced with the assistance of AI translation services.