Will the Oil Price Recovery Hit a Ceiling on Demand Destruction?

When the oil and gas sector saw a significant amount of demand disappear at the beginning of the Covid-19 pandemic, some investors saw a value opportunity and decided to invest in the sector at rock-bottom prices in order to reap the benefits of demand recovery.

For those who bought oil and gas stocks towards the end of 2020, this has proven to be a prudent investment so far. The price of Brent crude has traded between $60 and $80 per barrel since March, showing significant recovery from lows of $20 to $30 per barrel in early 2020. The stocks of oil and gas companies have recovered accordingly.

However, as oil prices begin to test $80 per barrel, some analysts are predicting that the industry is headed toward demand destruction. While higher oil prices can be a good thing for suppliers, they can eventually get to the point where consumers will buy less due to affordability issues. With economic troubles persisting in several major economies and inflation on the rise, it seems a very real possibility that the growth of profitability in the oil sector could hit a ceiling.

“Oil prices have disconnected from the marginal cost of supply. Instead, they are travelling to the level where demand destruction kicks in, which we estimate at ~$80/bbl,” wrote Morgan Stanley (

MS, Financial) in a note this past June.

Supply troubles

Oil supply is getting tighter as producers seemingly underestimate demand growth. OPEC maintains its slow road to adding supply even though there were 3 million barrels of crude per day of inventory draws in the last month, compared to 1.9 million barrels per day drawn in the previous months of this year.

In addition to supply shortages, there are also supply chain issues in some regions due to various reasons. For example, in Europe, a lack of truck drivers has resulted in a shortage in the amount of gas being delivered to gas stations.

Meanwhile, China is reportedly facing its worst power shortage in a decade as extreme weather combines with growing energy demand and strict limits on coal usage. Several provinces have been rationing energy, including Guangdong, a manufacturing province that accounts for over 10% of China’s economic output.

Even though the solution to shortages would be to increase supply, not every supplier would see a benefit in upping production. Each producer has a minimum price per barrel that is necessary for them to earn a profit on the investment necessary to produce each barrel. If they were to increase production and drive prices below their profitability level, it would only be shooting themselves in the foot.

In response to supply crunches and soaring energy prices, China and India, which are among the top oil importers in the world, began selling oil from their strategic reserves this month. This move hasn’t done anything to lower global prices as it should have, though. According to Stephen Brennock, a senior analyst at London-based PVM Oil Associates, this signals that the problem may have more to do with price than with inability to find oil to purchase:

“The reason for this turn of events is price. At over $70/bbl, crude appears to have become too expensive for Beijing and New Delhi… Oil prices hitting $80/bbl will be a severe pain point for these key crude buyers and is likely to undermine import demand.”

Economic troubles

It’s not as if oil has never been this expensive before. In fact, it traded for more than $100 per barrel in the early 2000s due to skyrocketing demand in large emerging markets, including China and the Middle East. What has changed since then, one might ask, to make oil less affordable?

One reason for this is because the more commonplace something becomes, the less people are willing or able to pay for it. If electricity isn’t as common in a country, then a rapid period of growth can drive prices higher, and people are still willing to pay up because only the wealthiest can afford it anyway. However, with electricity consumption becoming a daily necessity for more and more people, an increase in price is more likely to price people out of the market.

Recent economic troubles are also putting downward pressure on the price that people can pay for oil. According to the World Bank, the delta variant of the Covid-19 virus is negatively affecting economic growth in the East Asia and Pacific regions. Even China is likely to hit a slowdown as it faces fallout from the Evergrande (

HKSE:03333, Financial) crisis.

Higher energy prices have also been one of the biggest drivers of inflation. According to the U.S. Bureau of Labor Statistics, while the overall Consumer Price Index has risen 5.3% in the past 12 months, this has been driven primarily by energy, which is up 12% over the same time frame. High inflation is a significant drag on economic growth and oil consumption.

A stagnating investment prospect

The oil and gas industry has been looking forward to price increases as the world’s economies have begun to recover from the initial onset of the Covid-19 pandemic. However, while demand has certainly increased, it may have increased too quickly for suppliers to keep up in a profitable manner, resulting in a slow response to upping production.

This strategy has met a line of resistance due to many factors, including further economic troubles in several major economies, rising inflation and supply chain issues. While these factors will hopefully turn out to be short term, one major long-term factor that could decrease oil prices is concerns over climate change. In the future, regulations such as China’s limit on coal usage will likely become more common, and as investments in renewable energy projects increase, the prices for cleaner sources of energy will become more competitive as well.

All this considered, it seems possible that oil prices have risen as much as they can for the time being. If prices increase, buyers might simply try to reduce the amount of oil they consume accordingly. There could, however, be further room to grow profits for companies that are able to profitably increase production.