The 'Peak Oil' sequel comes with a new twist

It's very easy to reverse-engineer grand theories of history to fit the price action. When oil spiked in 2007 and 2008, the theory of "Peak Oil" gained much more traction. The idea was that fossil fuels were finite, and that the point of maximum supply had been reached. Henceforward, it would grow more expensive as supply decreased.

Instead, we now know, high prices attracted new supply, most famously in the form of the US shale revolution, and the oil price went into the doldrums for years. Now, the new argument is about Peak Demand. With the world growing less oil-intensive, and strenuous efforts under way to move to alternative energy sources, the head of the International Energy Agency, Fatih Birol, is prepared to declare in the Financial Times that "peak fossil fuel demand will happen this decade." That potential peak has pushed Saudi Arabia and Russia to close ranks and book as much profit as possible while they still can to bolster their economies.

The Saudi-Russo rush to hike prices, as crude oil demand stays resilient before an ultimate peak, is also part of a wider show where Riyadh is increasingly challenging the US-dominated global order. 

We'll see if this peak proves any more durable than the last one. However, there is at least one big difference. Price action supported and drove the notion of peak supply; given the way the oil price has turned upward in the last few months, there's no similar support for peak demand. Indeed, Brent crude is now almost $95.

As the annotations should make clear, the main shifts in the oil price over the last decade have all been driven by geopolitics, and not by the forces of supply and demand in international financial markets. In 2014, the discipline of the Opec cartel broke down in what was widely perceived as an attempt to punish shale operators by bringing crude to a level that they couldn't operate profitably; in 2020, another breakdown reflected Saudi Arabia falling out with Russia; and the invasion of Ukraine evidently triggered the spike early last year.

The latest rally also owes much to geopolitics — this time, the alliance between Saudi Arabia and Russia that veteran oil analyst Jean Ergas of Tigress Financial Partners calls a "Pact of Steel." The reference to the prewar alliance between Hitler and Stalin is provocative, but this new arrangement is having a galvanising effect. The US responded to last year's price spike by drawing on its strategic petroleum reserve, which had been built up for just such a moment. This stopped Russia from holding the western world to ransom over the oil price. But having done so once, the US cannot drain its reserve again. America's oil inventories are far lower now, thanks to the depletion.

For an insight into the game that Saudi Arabia is playing, I recommend this episode of the These Times podcast, in which the Cambridge academic Helen Thompson asks how worried we should be about this current behaviour. In conjunction with the money the kingdom is splashing on sports, from setting up a rival to the PGA golf tour to paying silly money to bring Neymar and Ronaldo to the Saudi league, it's taking a newly aggressive role in the world. To quote Ergas, the strategy "is about telling the US that we can live without you." With its new markets to the east and its alliance with Russia, Saudi Arabia has put a floor of about $70 under the oil price.

Rather than attempt to explain this with reference to demand (which is rising for the time being) and supply, it's perhaps best to regard the latest Saudi alliance as what economists would call an exogenous event that could shock the rest of the world economy and financial system. Most importantly, higher oil prices act like a tax hike, taking money out of the pockets of consumers and companies and depressing demand. They could have a self-fulfilling impact in lifting inflation, just when it was thought to be licked. Rises in home heating or gasoline prices are instantly visible and very sensitive politically.

Almost as importantly, crude tends to lead expectations for future inflation. This shouldn't be so. If anything, higher oil today should mean lower inflation in future because of the base effect. But the relationship remains strong; higher oil prices mean higher inflation expectations.

The oil price is not as important to the global economy as it used to be. But it can still upset all kinds of plans across the world. Nowhere is this more true than in Europe….

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.