Oil, sometimes referred to as ‘black gold’, is unquestionably the worlds most crucial energy source. Since the 1950s, it started to quickly become the primary energy source, that underpins our modern society. Like blood vessels of the body, it is crucial for the economy to function, it can be moved around to wherever the energy is needed and it is the essential input required to move goods and people around the globe to their desired destination. Foremost, it is our largest energy source and currently accounts for roughly 1/3 of our energy consumption.

The following chart provides a good indication of our energy composition:

Over the last decades, oil has gotten a lot of bad press and there is a general attempt to reduce its usage in the future. Many people, who demonize the use of oil as an energy source, have spent little time doing proper research about the matter. Therefore I want to emphasize here — and it is hard to overstate — how important this energy source has been (and still is!), for economic development and human flourishing.

Most people think of oil mainly as an energy source, that is used to power machines, heat our homes and predominantly it is thought-about, as the key resource to move around vehicles. This is not wrong, about 2/3 of the oil is used as fuel in the transportation sector, to move cars, trucks, trains, ships and airplanes across the planet. However, oil is also a crucial component of most chemical products. About 1/3 of oil is used for industrial purposes, such as:

• Cosmetics (oils, waxes, perfumes, shampoos, conditioners, and hair dye).
• Lubricants
• Synthetic Rubber (e.g. sport articles, shoes, and tires).
• petrochemicals (almost all plastics are made from petrochemicals).
• Synthetic fertilizers and pesticides to produce food and keep it fresh longer.
• Asphalt
• Synthetic Fibers

Since oil is such an important ingredient in so many aspects of our daily lives, it follows, that its price has a tremendous effect on economic activity. Falling oil prices make it cheaper to produce products and ship them around the globe. Hence, sinking oil prices literally ‘fuel’ economic growth. For the same reason, a rising oil price is a major contributor for economic slowdown and inflation.

Further, since oil is so important, but reserves are limited and located in certain regions, it has always been a source for geopolitical considerations and tensions.

The following chart provides a nice historical perspective on the oil price and how it reacted to economic and geopolitical events:

Notably, oil saw a huge price increase, triggered by the Arab oil embargo in 1973. During the 70s, which was a period of high inflation, there were a lot of tensions between the Organization of the Petroleum Exporting Countries (OPEC) and the U.S. In the 80s, the price came down and remained fairly low for the following 15 years. Throughout this time, the oil market was essentially dominated by state-owned companies of the OPEC countries. In the 2000s, the oil price started its massive rise, culminating in the 2008 financial crisis and was followed by a crash. Thereafter, the price started to move up again until it collapsed in late 2014. This was influenced by the availability of cheap capital, accompanied with new technological advancements, which enabled the access to new sources. This so termed ‘Shale Revolution’ enabled the U.S. to massively increase their production and become the largest oil producer.

After the pandemic shock (in which oil futures even briefly traded at a negative price), we saw a continuous rise in the oil price and this rise was magnified by the invasion of the Ukraine and the subsequent sanctions against Russia.

It can also be observed, that oil is volatile and the price-swings are quite substantial. This is partly due to the fact, that it is not only driven by markets, but is rather heavily influenced by political decisions.

There are some things that are important to comprehend, when thinking about the market structure. Fundamentally, the oil market is set by supply and demand.

• The process of exploring and ramping up drilling wells is a quite complex and time intensive process which requires a lot of capital expenditure.
• The demand is also relatively stable since it is often difficult or imposes high friction costs of changing from oil products to alternatives. But the demand is not as stable as the supply:
  • A downturn in economic activity can reduce the demand substantially.
  • High price increases will lead consumers to rely on substitutes wherever it is possible.

This is why the price swings are so extreme. The continuous supply that is drilled out of the wells remains constant in the short and medium term — unless there is direct political meddling, such as OPEC restrictions or import embargoes. Hence, the oil price is predominantly driven by the general economic and political outlook.

To get a better understanding of the geopolitical implications, it is important to have some idea about where it is produced and where it is demanded.

The United States, Russia and Saudi Arabia are by far the largest oil producers. However, it doesn’t follow, that these countries are necessarily also the beneficiaries of rising oil prices. For instance, even though the United States is the largest producer of oil, it has such a high consumption, that it is a net-importer of oil. Hence, while American oil producers benefit from rising oil prices, America as a whole is negatively affected.

The following chart shows the net imports of oil (the darker, the more oil is imported):

The major net importers are Asian countries and their oil requirements are also rapidly growing, especially China and India. This is also one aspect, why these two specific countries are very reluctant, to follow the Western nations, in holding back from Russian oil imports. From China’s and India’s perspective:

• They already require a lot of oil imports and given the already painfully high prices, they rather take the discount that Russia provides.
• If they also put forward embargoes on Russia, the oil prices would tremendously skyrocket, since 12% of supply would totally disappear from the market and all importers would be bidding for the remaining supply.
• They are also not able to simply give out additional money to their huge populations, to compensate for the rising costs, as Western countries currently do. (Actually, Western countries are also not really in a position to do that, but they do it anyway).
• They are aware that if they want to keep growing and enjoy the same standard of life as OECD countries do, it will require a massive increase in oil consumption.

Meanwhile, western countries have been in a quest to drastically reduce oil consumption, by meddling in the energy market with political measures and mandates, to discourage investment in this sector. On the other hand, they have heavily subsidized and encouraged the development of renewable energy sources.

As a result, there has been very little capital expenditure towards oil exploration and production over the past decade. Thus, it is likely to see rising demand, facing an inadequate ability to increase the supply.

Moreover, the recent rise in energy prices is met with populist hostility against oil companies ‘benefiting’ from the war by making profits. Many countries consider (or already did impose) windfall taxes on energy companies. These companies massively underperformed over the last decades and now that they are profitable, they get penalized for it. In other words, investors who took the risk of investing in these companies and got little returns, while almost everyone else made massive profits, are now asked to pay additional taxes. This should have another discouraging impact on investment in the oil sector.

Lastly, recessions have been periods, in which the oil price tends to substantially decline. This is due to the largely reduced economic activity bringing down the demand, while the production doesn’t just halt. However, given all the factors stated above, I am doubtful that this will be the case if we should really enter a major recession.