The performance of different asset classes in the third quarter of the year tells the whole story. Oil prices shot considerably higher. With the exception of RBOB, which disappointingly underperformed, partly due to the spec change in September, the rest did reassuringly well. Every dollar invested at the end of 2Q would have returned anywhere between 27% (Brent) and 41% (Gasoil) with WTI and Heating Oil in between. The noticeable strengthening of the crude oil structures also suggests physical tightness and supply deficit. Front WTI spread flipped from contango to a backwardation of $2/bbl. Brent behaved in a similar fashion.

Conversely equities lost value. The MSCI All-country index fell 3.82% in the third quarter of the year and the Nasdaq Composite index retreated 4.12%. Chinese malaise is reflected in the 2.86% loss in the value of the Shanghai Composite Index and the ominous global economic outlook forced investors to escape into the dollar; its index strengthened over 3%.

The global oil balance was always going to get tighter in the second half of the year. According to the IEA, the call on OPEC will increase from 28.35 mbpd in 1H to 29.05 mbpd in 2H. OPEC observes the same trend but is considerably more upbeat. It sees demand for its oil inflate from 28.47 mbpd to 29.98 mbpd. What was intriguing to observe was that the latest leg up began almost on the first day of the third quarter, although rising demand for OPEC oil had been widely anticipated beforehand.

The bull market we experienced in the previous quarter went against downgrades in global oil demand, which, in turn, was the function economic concerns. Between June and September, the IEA cut 2H demand estimates by 900,000 bpd, from 103.45 mbpd to 102.55 mbpd. The 4Q downgrade was a full million barrels a day. OPEC has taken a significantly more sanguine view and its downward revision stood at 20,000 bpd for 2H and 70,000 bpd for the October-December period.

Despite gloomy demand prospects oil rallied relentlessly. The main catalyst was the decision from Saudi Arabia and its non-OPEC ally Russia to create a wider supply deficit by voluntarily cutting production and exports. As the two major oil producers kept extending the deadline for these constraints (currently the move will run until the end of the year) oil investors had no choice but to keep or increase their exposure. The latest update on the global oil balance implies that the world will need 28.9 mbpd (IEA) or 30.71 mbpd (OPEC) of oil from cartel in 4Q. Assuming an output level of 27.4 mbpd, the global stock depletion will be ample (IEA) or mammoth (OPEC).

Once it is established that the last quarter of the year will be tight chiefly due to scarce availability of the black stuff the question is how long this deficit might last. The voices of those who are expecting an announcement of a gradual easing of the restraints at the next OPEC+ meeting tomorrow are getting louder although these claims, at this stage, are somewhat unsubstantiated. Nonetheless, such a move, which could come into effect from January, would ostensibly limit the upside potential but would not entail an unconditional and immediate bear market. Consumers, namely the US, might try and alleviate the situation by tacitly or explicitly allowing Venezuelan and Iranian oil back into the market as the race for the White House will intensify shortly.

The grim economic outlook, which has had an adverse impact on global oil demand in the second half of this year is the result of stubborn inflation and persistently elevated interest rates. Although headline and core inflation readings are mitigated in major economic power houses the desired 2% target level is still not within reach. In the euro zone consumer prices in September rose by 4.3%, the lowest increase for two years. Core inflation retreated from 5.3% in August to 4.5% in September. US August CPI rose from 3.2% to 3.7% but the core number fell to 4.3%. The August core index of Personal Consumption Expenditure, another salient set of data for the Fed, rose by 3.9%, down from 4.3% in July.

The success of the fight against inflation is tangible (more in Europe than in the US) but the finish line is not in sight yet. Data driven central banks have concluded that doing too little is potentially more damaging than doing too much. Thus, interest rates in the US, in the euro zone and in the UK, although possibly peaking, are to stay high in the foreseeable future. Life will remain expensive. Of course, the situation remains fluid and the challenge is to try and stay intellectually flexible and change the tone if warranted by forecasts or data. Currently, however, the economic backdrop is inauspicious for oil demand, something that the strong dollar and inverted bond yields both confirm. Sentiment is presently shaped by supply considerations. Stock depletion is penciled in for 4Q. Whether the 3Q rally that is likely to spill over for the remainder of the year is maintained in 2024 depends on the performance of the global economy. However, the latest snapshot shows a dispirited picture.

Although the underlying oil balance is still expected to remain tight for the rest of 2023 the current quarter kicked off on the back foot for a combination of reasons. The resolutely strong dollar has finally caught the attention of oil investors and provided a valid excuse to flush out weak length. The announced restart of the Iraq-Turkey pipeline that was shut down after the earthquake in February and the latest Reuter survey that showed a rise of 120,000 bpd in OPEC’s September output have also contributed to yesterday’s sell-off. This correction still seemingly has legs to run and is also aided by the weak rouble. The Russian currency has exchanged hands at 100 to the dollar this morning raising concerns that it will serve as a stimulant to hit the production accelerator as hard as possible. The stars might be aligned for further weakness, nonetheless the anticipated depletion in global stocks will plausibly push prices back to recent highs in coming weeks. On the other hand, the current retracement is a red flag that conspicuous global economic headwinds and continuously high borrowing costs will negatively impact oil demand and will make a sustained break over the $100/bbl mark more of wishful thinking than a fundamentally justified scenario. 

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