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What Is Demand Destruction?
Last month, analysts at JP Morgan said crude oil prices would struggle to break above $85 a barrel.
The reason – demand destruction.
As we note in our main story, crude oil topped out just shy of $85.
Is this number magic?
No. It’s the price where people make alternative choices.
Back in the economics class we all slept through, we learned a concept known as elasticity.
In a nutshell, elastic products can increase or decrease in price and not see demand drop off much.
Inelastic products are very price sensitive. Even small increases in price lead to a significant drop in demand.
Food is considered elastic because we have to eat.
But specific brands of orange juice are inelastic because we can easily switch to a similar product under another brand.
Oil is fairly elastic, up to a point.
Near $85, the calculus changes.
That’s the point where we start seeing conversion to non-fossil fuels and decisions to forgo road trips.
As the cost of renewable energy expands along with its usage, we’ll see this price cap drop lower and lower until oil usage is more rare than common – the opposite of renewables and oil right now.
For consumers, that means there’s a cap on the price we pay at the pump.
In fact, as the recent drop in crude oil prices shows, once we near that destruction point, there’s more downside than upside risk.
Keep that in mind when you invest in the energy sector.
What’s up with crude oil?
Crude oil was hotter than Kim Kardashian and Pete Davidson.
Apparently, neither could last.
In the last week, crude oil prices dropped ~20%.
From the high just shy of $85 in mid-October, the black gold is down nearly 25%.
The Oil Volatility Index, which measures expected price change in crude oil prices (think of it like a forecast), spiked to its highest levels of the year.
Typically, that creates ‘capitulation’, a market effect where volume soars effectively washing out all the sellers (on drops) or buyers (on rallies).
Oil-producing countries met today, deciding to stick with their output hike in January.
Ahead of the meeting, representatives chastised recent moves by the U.S., China, and other countries to release strategic oil reserves, saying it would add to an expected surplus in 2022.
Yet, even as Omicron weighed on forecasted demand, members felt that production increases in January wouldn’t depress oil prices.
Plus, the UAE continues to push for increased outputs as the tiny country tries to capitalize on one of the largest reserves in the world before everyone switches to green energy.
However, the OPEC+ representatives released statements that they would adjust production as needed to meet market conditions.
Translation – we’ll cut oil output to keep prices elevated.
The Bottom Line: Don’t expect gas prices to meaningfully fall anytime soon.
In the meantime, names within the oil and gas energy ETF XLE and exploration and production names within the XOP ETF have pulled back significantly on weaker oil prices.
That’s provided a second chance for investors looking to play names like Exxon Mobil (XOM) or Schlumberger (SLB).