Continuously Re-assessing the Oil Balance
Oil prices are not so much influenced by developments as by the interpretation of events. And the market voted with its dollar last week. Thursday’s price action was particularly brutal. It greatly contributed to the front-end structure of both WTI and Brent turning into contango. The bloodbath was aligned with a pronounced weakness in the physical market where the European crude oil marker was also pushed over the precipice and its $2/bbl premium over the forward contract completely eroded by Thursday. Consolation arrived at the end of the week as pre-weekend short-covering and OPEC’s plausible and aptly timed response to the carnage helped the complex re-claim some of the lost territory in outright prices, as well as in spreads.
Whilst it is open to debate what the fundamental justification for the not-so-sudden change of sentiment and for the intensifying selling pressure might be, the most obvious factors are the realization that the bullish rhetoric advocated by OPEC does not have as much merit as it was deemed and that borrowing costs will stay high well into 2024. Because of the financialization of the oil (and other) derivative markets trends are usually exaggerated since financial investors do not exclusively act on fundamental developments, their modus operandi is very often akin to airlines hedging their jet fuel purchases – it is not necessarily done out of conviction but because of fears of losing their comparative advantage over those who do swing into action – aka herd mentality.
OPEC, and to a lesser extent the IEA, has been reassuringly sanguine on global oil balance, particularly in 4Q. To reiterate the latest numbers the former sees demand for its own oil at nearly 31 mbpd for the last quarter of the year whilst the latter puts it at 29 mbpd – both implying global and consequently OECD stock draws. This would logically mean that US commercial stocks, which make up around 44-45% of OECD industrial oil inventories should be depleted at a fast rate. Well, they are not. The latest Weekly Petroleum Status Report, which recorded hefty swelling in crude oil stocks, puts US commercial oil inventories at 1.263 mbpd, a little bit lower than at the end of 3Q, on par with the 2Q level and considerably (40 million bbls or more than 3%) above year-ago stockpiles. At the same time, using the OPEC estimate as a reference point one would find that OECD oil inventories should end the year meaningfully under the December 2023 reading – 113 million bbls or 4% below it, to be precise.
There is a conspicuous discrepancy between the two figures (albeit admittedly a pear is compared with an apple, yet they taste similar). This yawning gap is the function of diverging views on supply as well as demand. In a notable development and despite the Saudi resilience of sticking to the 1 mbpd of voluntary output constraint, production from the OPEC+ group has increased around 700,000 bpd between August and October, including member countries without output ceilings. Add to that Russia’s continuous and successful attempts to obfuscate its production/export levels and rising US output and it is a fair assumption that the supply side of the oil equation looked more price supportive a few months ago than it currently does. The increase in physical supply has triggered an outsized jump in financial supply.
The demand side is turning equally disheartening. The impact high borrowing costs have on the thinking and action of money managers was extensively covered in Friday’s note. Physical and financial demand goes hand in hand, one affects the other, even if the reaction in derivative markets to changes in consumption can be aggravated for reasons mentioned above. Despite tangible mitigation of inflationary pressure in the US, the euro zone and in the UK, central bankers are more than cautious and conservative about advertising interest rate cuts in the foreseeable future. There are two possible explanations for this pragmatism. Firstly, core inflation is still considerably above the self-imposed goal of 2%. Secondly, monetary policy makers, especially in the US, are all too aware that during the two major disinflation periods of the 1970s and the early 1980s core inflation was irrevocably reined in after a considerable rise in unemployment. In the mid-1970s, for example, core inflation only started to cool off when the rate of joblessness jumped from 5% to 9%. What is likely to worry rate setters is that the labour market is still almost disturbingly tight, therefore they would be inclined to keep the price of lending at elevated levels. Whilst the plausible halt of rate increase is an unreservedly welcome development, high borrowing costs are putting and will continue to put financial burdens on households, companies, and governments. And if this is the case the demand outlook is ominous.
We have been of the view that projections for a tight oil balance in 2024 are overestimated, chiefly because of the ‘high-for-longer’ perception. Yet, we were convinced that the Saudi supply cut together with the ostensibly bullish 4Q demand forecasts will result in one more upside push in prices. Plainly, it has not been the case and in retrospect the Saudi unilateral action to stabilize or support the market has proven as effective as applying Band-Aid to high blood pressure. In the light of last week’s obliteration of oil bulls, some kind of response was forthcoming from the producer group. It duly arrived on Friday when the wheels of further supply cuts were set in motion by unnamed OPEC+ sources. With the meeting still a few days away, details are understandably sketchy, but the message is clear. If additional cuts are agreed, a short-term price boost is expected but its longer-term price impact seems dubious as enforcement and adherence will be the salient issue. The November 26th meeting will be an intense one where a complete breakdown of unity cannot be fully discounted either. It is nigh to impossible to convincingly argue for or against either of these scenarios. Common sense should dictate that a supply war will be avoided, and no violation of this year’s bottoms is impending. On the upside, nevertheless, bleak economic prospects will make the oftentimes cited $100+ price target growingly onerous to achieve - unless oil is weaponized.
20 Nov 2023