Oil refinery 1

The oil price has been rising – the price per barrel is now hovering around its highest level since the end of 2014. One obvious impact is that the price of petrol will rise, meaning most of us will be a little worse-off. But a bigger question casts a worrying shadow.

The oil cycle is as old as the oil industry. And it works in a fashion that is actually quite predictable.

Price, as you know, is determined by supply and demand. If the price of something rises, supply increases, and demand falls. But with oil it is subtly different. And it is different because of time lags. Sure, when the oil price is high, supply rises, and demand falls, but not straight away. It takes time before the reaction to a high oil price has an effect. When oil is expensive, oil companies spend more on exploration, but it takes time before this leads to higher supply. When the price is high, consumers, may gradually change habits – like drive more energy efficient cars, or fit solar panels to their roof, but not straight away.

The same applies but in reverse when the price is low.

For this reason it can take many years for the oil price to complete a cycle. Since the early years of this century, the oil price has oscillated between less than $30 a barrel and over $100.

It traded at less than $30 in the early noughties, from around 2004 it started to rise, eventually going close to $150 in 2008. After the 2008 finance crisis it crashed, falling to less than $30, but picked up within a couple of years, passing $100 earlier this decade. In the summer of 2014, it was trading at over $110 a barrel. 18 months later it fell below $30.

At the time of writing, Brent Crude oil is at $68 a barrel.

Two factors are muddying the water. Shale gas and renewables/climate change.

Shale gas is relatively inexpensive to turn up or down – or to put it another way, the time lags in the supply and demand shift are shorter with shale gas. Up to now, shale gas has kept a lid on the oil price. Every time price has crept above $55, shale gas output has risen, forcing the price back down. But supply of shale gas is limited. There are bigger forces at play. It cannot, on its own stop, the turning of the oil cycle, merely delay it.

Renewables/climate change is a new game changer. Climate change is creating the imperative to reduce consumption of oil, renewables are falling in price so fast that the cost of weaning ourselves off oil is falling. But it will take time before the combination of climate change and falling renewables have a noticeable effect on the oil cycle. When they do, the cycle may die, but this is not likely for several years.

In the meantime, the oil price is rising.

The latest jump was put down to the instability in Iran.

But deeper forces are at play. As was told here yesterday, global manufacturing is in good shape. The global economy is looking healthier than it has done for years. This is leading to rising demand. In the US, oil inventories are falling rapidly.

If history is any guide, the oil price will pass $100 eventually – maybe later this year, maybe next, maybe in 2020 – but it will happen.

This will in turn, lead to rising headline inflation – hitting households. The oil cycle tends to correlate with the economic cycle. When the economy booms, the oil price rises, when the oil prices reached a certain level, the economy slows.

If the timing of the oil cycle is such that oil price rises just as central bankers start to raise interest rates, then the combination of higher rates and higher oil prices can lead to recession. This timing seems to be precisely what we are seeing at the moment.

It won’t happen this year, and probably not yet. But maybe it will in 2020. But will the next recession in the US occur before or after the next presidential election?