Oil price surges as cycle turns, will the housing cycle dip?

The oil price is up again. This is good news for oil companies. The oil cycle is at work. I think there is a parallel with the housing market.

Article updated: 18 May 2018 9:00am Author: Michael Baxter

The oil price

Of course, the oil price matters. When it’s high, a slowdown in the western economy follows. Just before the 2008 crash, the oil price was at a record high - near $150 a barrel.

The economic pick-up, which we have seen over the last three years, coincided with sharp falls in the oil price, which dropped from around $110 in the middle of 2014 to around $30 at the beginning of 2016.

If you want an explanation for the rises and falls in the economy, then the oil cycle maybe it.
As I speak, the price of Brent Crude is just a few cents shy of $80 a barrel. Over the last year, it has risen by more than two thirds.

Even before President Trump’s decision to pull out of the Joint Comprehensive Plan of Action with Iran, the oil price was rising steadily.

The last three years have been good for the global economy and demand for oil has risen by five million barrels a day or five per cent. China is not growing like it used to, but the Chinese economy is much larger, which means smaller percentage growth can have just as big an impact on actual growth in oil demand.

Meanwhile, the oil frackers cannot keep up. At the current oil price, fracking is very profitable – or at least it is for some sites. But the global economy is vast, US frackers are not like Atlas, they cannot support the world - or at least global demand for oil - upon their shoulders alone.

“This is an incredibly bullish set-up where we have Iran sanctions being revisited, Venezuela elections on May 20 and the situation in Yemen and Libya,” Gary Ross, head of global oil at S&P Global Platts and the founder of Pira Energy, recently told the FT. He added: “The risk of an asymmetrical supply disruption materialising now is even greater than it was during the Arab Spring.”

Paul Horsnell at Standard Chartered, said: “Shale oil economics are no longer the most important price-setting factor.”

Recently, the International Energy Agency (IEA) forecast that between now and 2023, growth in the supply of oil, mainly from fracking, would keep pace with demand, and possibly exceed it. But it forecast that by 2023, supply would no longer keep pace with demand and that presumably, the oil price would then surge.

But then IEA’s forecasts do not have the best track record - I suspect it is probably underestimating demand growth. Besides, fracking is not the panacea people think it is – I am cynical about its long-term viability, a process that involves injecting such huge volumes of water underground seems like a recipe for disaster, to me.

The cycle

But there is a deeper force at play: the oil cycle. Over time, the price rises, and it falls. When the oil price is high, you hear no end of reasons why it will never fall again. You hear about peak oil, about why demand will always exceed supply. Back in early 2008, anyone who predicted oil falling back below $70, let alone $30, would have been laughed at. Yet the oil price fell to around $30 in 2009. In 2012, it was back over $120, and in 2016 back to around $30. Right now, it is in-between, but the trend is pointing up.

I think that the reason for this lies with the difference between short and long run price elasticity of demand and supply.

When demand and supply is price inelastic it means a change in price has very little effect on either demand or supply. The narrative continues, we need oil. If the price is high, we keep buying it in the same quantities as before. Suppliers cannot ramp up supply just at the drop of a hat.
But in the long run, it is different. If the oil price is high for an extended time frame, consumers change habits. They start buying more fuel-efficient cars, prioritise finding a job closer to home, insulate their roof. This takes time, but in the long run, demand for oil is price elastic.

Likewise, for supply. When the price is high, companies invest more in exploration or in trying to find innovative ways to extract oil.

Long-term, demand and supply of renewables fluctuates with the oil cycle too.

These forces take time to exert a noticeable affect, that is why the cycle moves so slowly. But they do take their toll eventually.

The reverse happens, of course, when the oil price is low. We are more relaxed about driving a petrol guzzling car. Investment into exploration drops sharply.

It takes time, but the oil cycle continues to rotate.

Housing cycle

I wonder whether there is a similar, but more elongated cycle in the housing market.

House prices have begun falling. They probably won’t crash, but in the longer term I am not so sure. See House prices tumble as oil surges, but is there a connection?

The accepted wisdom is that there is a shortage of land, ergo house prices always go up.

But I believe the view that house prices always increase is lazy thinking.

Factors at play which can affect supply include:

  • Innovative ways of construction, in which most of the construction is done off-site, in factories, subject to automation, and then erected on site in a couple of days.
  • Innovative ways of finding alternative sources of supply, such as ship containers as the shell of a home or living on house boats.
  • By developing run-down areas, where land is cheap.
  • Via new technologies, such as hyperloop, when it is ready, connecting areas where land is cheap to prosperous areas such as the cities.
  • Via technologies such as augmented reality supporting remote working.
  • Demographics: the population is either falling or about to fall across much of Europe. This will lead to surplus supply of housing stock and new technologies will connect areas with high supply to areas with high demand.

Recall, also that across the UK, roughly six million homes are under-occupied, broadly meaning two or more spare bedrooms. The cycle will apply to house prices just as much as the oil price.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

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Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.