Anyone questioning the price driver behind the current oil price rally just has to have a glance at yesterday’s settlement prices to realize that it is supply. Oil rallied, well, in most cases, but equities retreated. Tuesday’s announcement of the extended Saudi/Russian joint cut until the end of the year led to growing conviction that scant availability of crude oil will lead to depleted stocks and tightening balance. The Saudis themselves are confident that the demand for their oil in October will exceed the reduced supply, hence the increase in differentials to Asia. The anticipated stock depletion was confirmed by last night’s API data which showed crude and gasoline stocks plunging more than 5 million bbls with distillates up 306,000 bbls. The wind has been taken out of the bulls’ sail overnight by rising Chinese product exports last month albeit crude oil imports rose 31% on the year.

The subdued performance of Heating Oil and Gasoil is perplexing; probably it was the function of forecast US stock build. What is, however, intriguing to observe is that this weakness is predominantly focussed on the front end. It might imply that from next month when refinery turnaround and the beginning of the heating season gets under way inventories will decline and Heating Oil will once again take over the role of the forerunner.

The drawn-out supply constraints have clearly helped shape investors’ sentiment, but no such support was impending in equities. Stocks suffered a setback because stronger-than-expected reading of the US service sector raised fears of elevated interest rates. The non-manufacturing PMI of the ISM jumped from 52.5 in July to 54.5 last month in the latest sign that any hopes for an imminent rate cut are misplaced. Contracting Chinese exports and imports in August also create economic headwinds this morning. The impact of the present supply restrictions is there for everyone to see, nonetheless the move might come back and haunt the instigators in 2024. 

GMT +1	Country	Today’s data	Expectation
09.00	Euro zone	GDP Growth Rate YoY 3rd Estimate Q2	0.6%
12.30	US	Initial Jobless Claims Sep/02	234,0000
23.50	Japan	GDP Growth Annualized Final Q2	5.5%

 

Dubious Sustained Price Strength

Despite yesterday’s sell-off Tuesday’s decision from Saudi Arabia and Russia to extend supply constraints until the end of the year created an even more auspicious fundamental backdrop for oil bulls than previously anticipated. Analysts now expect a supply deficit of well over 2 mbpd for the rest of the year. It is massive and should provide invaluable price aid for the months ahead since global and OECD oil inventories will experience overwhelming drawdowns. Maybe, another layer of support will come from the dollar. The US is conspicuously more successful in its fight against inflation than EU or the UK, consequently the Fed is more likely to pause rate hikes than the ECB or the BoE paving the way for a weaker dollar in the next month or two.

Even though the immediate future is buoyant, the perpetual dilemma is whether elevated price levels can be maintained. After all, precedent was set between 2011 and 2014 when a barrel of crude oil reliably traded around and above the $100 mark for 3 years. It is, therefore, worth comparing the circumstances 10 years ago with the current environment. When one does just that the contrasts become blatantly stark.

The major difference between the 2011-2014 period and 2023-2024 is that albeit oil was more expensive back then, life was not. To begin with, inflation was considerably below the current level. Taking 2013 as a basis for comparison US CPI was under 1.5% with the price of WTI fluctuating between $92/bbl and $107/bbl. Because of low inflation the US central bank was not forced to adopt restrictive monetary policy. The 10-year bond yield was decisively under 3% and the Fed kept its benchmark interest rates close to 0%. It was attractive and tempting to borrow and it kept the economy ticking.

Fast forward 10 years and the picture could not be more ominous. Although inflation dropped from the high of 9.1% in July last year to 3.2% in July it is still above the Fed target of 2% and higher than in 2013. Core inflation at 4.7% seems especially sticky. The 10-year bond yield is above 4% and interest rates in the US were raised from 0.25% in March 2022 to 5.25% in July, to levels last seen in June 2006. When pent up demand based on the Covid support ceases to exist, and it cannot be far away, consumer spending, which rose 4.2% in July on the previous year, will inevitably suffer and given that it is responsible for two-thirds of the economic activity, its impact will permeate throughout the economy.

The outlook in China, as discussed on the pages of this report last week, is even bleaker and the signs are anything but encouraging in Europe. The former trendsetter of the continent’s economy, Germany, is becoming the sick child of it. Its economy stagnated in the second quarter as the slowdown in China hurts, and weak purchasing power, empty industrial order books and stale household consumption all have a profound impact on the wider region. The geographical proximity of Europe to Ukraine also exacerbated the inflationary effect.

Undoubtedly, central banks’ efforts of taming inflation are bearing fruit. Nonetheless, the progress, alas, is slower than previously anticipated. Peak rates could be within spitting distance, although prolonged rate pauses are not a dead certainty. Rate cuts, on the other hand, might have to wait longer than previously hoped for. If you buy into the comparison with the 2011-204 period when low borrowing costs assisted economic growth than this time around expansion might face significant headwinds and slowdown might become the catch phrase.

The above-mentioned projected depletion in global commercial oil inventories resulting from the voluntary supply constraints, scarce product availability in September and October due to refinery maintenance and a potentially weaker greenback should keep oil prices resilient this year. Yet, the “higher-for-longer” mantra regarding borrowing costs will hinder global oil demand growth come 2024. It is already reflected in next year’s supply-demand data. The IEA sees 2023 demand growth at 2.25 mbpd, which will plunge to 1 mbpd next year. Further downward revisions cannot be ruled out, especially if the Chinese economic revival fails to get under way. Elevated 4Q oil price will do nothing to ease inflationary pressure, which, in turn, could further push the timeline for rate cuts out. And finally, slowing demand growth might shepherd attention back to the significant increase in global supply cushion, another potential bearish factor for 2024. To simplify this view, the perceived and notable gap in the 2013 and 2024 interest rates makes any sustained price rally highly implausible.
 

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