It is easy to resist everything but temptation. After plummeting $15/bbl in a month it was more than enticing to look for a bargain. The words out of the Vienna headquarters of OPEC were heard loud and clear by the investment fraternity, consequently the above-mentioned dump in oil prices has been followed by a rally of almost $5/bbl in just two days. The prospects of further reduction in oil production provided an unmissable opportunity to get back into the market from the long side. And when this chance presents itself in conjunction with rising equities and a weakening dollar, all of the sudden as daily jump of nearly $2/bbl seems the new norm and more will be anticipated. Slight worry is that the two major crude oil contracts still display contango on the front-end and Dated Brent is still assessed under its forward peers for the remainder of the year.

No doubt that the upcoming meeting of OPEC+ energy ministers will be one of the most pivotal of recent times as investors are searching for clues whether the hints and rumors will be backed up by action. Given that the judgement day is Sunday volatility will inevitably pick up towards the end of the week and every single word of the decision makers will be scrutinized on the level of a Jay Powell press conference in the run up to the meeting on November 26th.
 

Deja vu

Long gone are the days when the most pertinent variable in the oil balance and therefore in the formation of oil prices was global and regional demand estimates. In fact, it was so palpable that annual global oil demand and average oil prices used to correlate around 90%. The 1997-2007 period is the best example of this powerful relationship. The reason behind it is probably twofold: firstly, the global economy was powering ahead due to the rise of East Asia and within that China coupled with the increase in productivity triggered by technological advances. The rise in global oil demand was broadly uninterrupted. Secondly, OPEC was the reliable central banker of the oil world, whenever demand inflated, they raised the oil equivalent of interest rates, output, always ensuring that this delicate balancing act did not lead to oversupply – similar to central banks’ current aim of soft landing.
Then the Great Recession of 2007-2009 dented oil demand. It was followed by the euro zone debt crisis that rocked the financial world and at the same time the supply side of the oil equation grew in relevance with the emergence of the US shale industry. The newly found competition between OPEC and later OPEC+ and shale producers led to price crashes in 2014 and 2018 whilst at the height of the Covid-pandemic the internal supply war between Russia and Saudi Arabia briefly sent the price of WTI into negative territory. Oil production has become a force to reckon with.

In the second half of this year, oil demand has once again turned out to be the dominant factor but this time around it has had an adverse impact on oil prices just like in the 2007-2009 period. Despite the efforts of the OPEC+ producer of taking 3.66 mbpd of production off the market together with the voluntary 1.5 mbpd reduction from Saudi Arabia and Russia oil has been failing to gain traction. So, why have oil prices fallen from nearly $98/bbl to below $77/bbl in the space of less than two months basis Brent?

As implied above, demand is responsible – not so much absolute figures but the gradual realization from forecasters that constantly high interest rates will create significant headwinds for the global economy and consequently for oil consumption. Looking back at the July-November period, 2024 demand estimates tell the whole story. July was the first month when all the three agencies published projections for 2024. Fast forward four months and one will find that these numbers have been revised down considerably by the EIA and the IEA, whilst OPEC, unsurprisingly, stayed stubbornly buoyant. The EIA now sees next year’s global consumption 360,000 bpd below the July level and IEA downgraded its own findings by 320,000 bpd (admittedly both produced upside amendments from October to November). The icing on the cake was the increase in non-OPEC supply predictions leading to a considerable fall in OPEC call. OPEC, on the other hand, has seen resilient oil demand for next year and its latest projection is 110,000 bpd higher than in July.

The market has heeded the EIA/IEA narrative. The most plausible explanation for their cuts in next year’s demand is interest rates. Although the rise in inflation has been mitigated and consumer prices are increasing at a much slower pace than last year the war has not been won. Central banks halted the increase in borrowing costs but since monetary policy makers only set overnight rates, bond investors are tasked with pricing futures interest rates. And the 2-year Treasury yield, for example, is unable to retreat significantly. It has been hovering under 5% for the past few months, occasionally breaking above it, implying expectations that borrowing will remain at elevated levels in the coming months and quarters. The continuous downward revisions in global oil demand have been the logical byproducts of these expectations and in case bond yields remain high further cuts in consumption estimates cannot be ruled out. It is under these circumstances that OPEC+ is floating the idea of additional production cuts. Again, playing along with the analogy, if central banks do not cut rates OPEC is forced to reduce production. The long-term impact of such a move, however, is questionable. Structural bull markets are always driven by growing demand, which is not imminent under the current scenario. Investors also take comfort from the fact that the deeper the cut the thicker the supply cushion. Any rally, therefore, is to be proven fleeting and a protracted price increase will only be supported by unquestionable demand growth that will be based on cuts in interest rates and a prolonged retreat in bond yields.
 

Overnight Pricing