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Why I think the oil price will recover but then crash forever

The oil price has plummeted. I think it will recover, and may even soar, before the oil market goes into permanent decline.

Oil demand is elastic in the long run. What I mean is that in the short run, demand for oil is roughly the same regardless of price. Or, to put it another way, in the short run, demand for oil is price inelastic.

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It takes time to change behaviours

In the longer run, it is different. If the oil price remains high, we start changing our behaviour: buying fuel efficient cars, for example. If the oil price remains high over an extended time-frame, then eventually demand falls and the oil price then drops — in the long run, demand for oil is price elastic.

It is a similar story with oil supply. If the price remains high, oil companies invest more in exploration. Bar a brief interlude immediately after the 2008 crash, the oil price was relatively high, from the middle of the last decade to around 2014,  occasionally going above $100 a barrel. During this period investment into oil surged, for example, the shale oil and gas revolution.

That’s why there’s an oil cycle. The delayed reaction of demand and supply creates extended periods of high and then low prices.

The collapse in the oil price 

Because of shale oil and gas, in recent years the oil price has been relatively modest. Thanks mainly to the coronavirus and also due to a disagreement between Russia and Saudi Arabia on the appropriate reaction to the pandemic, the oil price is currently exceptionally low — Brent Crude is at $33 a barrel.

You don’t need a degree in rocket science to realise that the low oil price will hit oil companies and their respective share prices.

As a result, investment into oil will fall. The longer the crisis lasts – until late spring, later this year, or next year when a vaccination is commonly available – the greater this negative hit on long-term oil supply. When the crisis ends, I expect demand for oil to soar. At that point, I reckon the oil price may even go close to $100 a barrel again.

Short-lived recovery

Just as markets initially underestimated the impact of the coronavirus because they failed to factor in the way it was spreading exponentially, they have failed to price in how exponentially falling costs of renewables and energy storage will transform the energy market.

The combination of the imperative to win the war against climate change combined with the economic transformation of clean oil substitutes will have a devastating and permanent hit on the oil industry.

Demand for oil won’t die away completely. It does, after all, have applications other than as fuel — plastics, for example. But then even the plastic market is being disrupted.

It will have an application as rocket fuel, but you may indeed need a degree in rocket science to understand that business.

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It’s ugly out there…

The threat posed by the coronavirus outbreak has spooked global markets, sending stock prices reeling.

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Against such a backdrop of market worry, it’s little wonder that many investors are starting to panic. (After all, nobody likes to see the value of their portfolio fall significantly in such a short space of time.)

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Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.