Garden Grove, CA - March 07: High gas prices at stations on the corner of Valley View Street and ... [+]
Although some are warning that oil prices might hit $200/barrel in the next year, it is just as possible that they will retreat to $60, depending on a wide variety of developments. The reasons for higher prices include sanctions on Russia, Iran, and Venezuela keeping as much as 5 mb/d off the market (most of that already shut-in), but also, ‘underinvestment’ in upstream activity squeezing future supplies while the global economy—and oil demand—return to and surpass pre-pandemic levels. These are serious concerns and point the way towards the ultimate bull market, where prices would be far above historical levels.
On the other hand, as economists often say, there are a variety of things that could lead to much lower prices in the coming months and this article will describe what can serve as warning signs of that. A caveat: I have a long history of bias towards predicting lower oil prices, and while I have often been right, I have also often been wrong, especially when political developments unexpectedly restrict oil supply. In 2008, just before the oil price collapse from its heights, I published two pieces called “Investing for the Oil Price Crash.” At the time many were warning of $200/barrel prices, but I thought the market was in a bubble and said so, to the opprobrium of many readers. That the prices dropped a month later did not represent amazing foresight on my part, but luck.
Two things that seem likely to presage lower prices: today’s (June 8) EIA Weekly Petroleum Statistics Report will give a sense of gasoline demand for this summer, as the product supplied numbers might dip because retailers discover that post-Memorial Day driving is less than expected. A weak driving season would pressure gasoline prices and refiners’ margins. Second, the June 15th release of the IEA’s Oil Market Report is almost certain to be bearish, with demand expectations downgraded and estimated Russia supply losses reduced. (See below)
Next, the global economy. Six months ago, the world economy was booming, the pandemic appeared nearing an end, and inflation was thought to be transitory, requiring no Central Bank action. Now, both stocks and bonds are down, bitcoins are crashing and consumer confidence has been moderating. Inflation is raising fears that another recession is imminent, in part because of Central Banks’ deflationary moves.
The greatest danger is of deflationary contagion, that is, a collapse in prices of a major asset group causing a retreat into cash, pushing down asset prices more generally including those for commodities and threatening recession. Of course, many such assets fluctuate wildly in these uncertain times so that any given day or week’s drop may not persist. Still, the degree to which asset prices drop and reduce global wealth is a major indicator of possible economic slowing.
Supply side surprises: There have been teasing hints of negotiations with Iran and Venezuela that might lead to an end to—or at least reduction in—sanctions on their oil exports. In both cases, rapid production and export increases are said possible, as much as 2 mb/d in a month or two. (Such claims should be taken with an unhealthy grain of salt.) At the moment, progress in both seems stalled but hints of renewed optimism would certainly cause a brief drop in prices. Once either or both appear on the verge of agreement, and especially after agreement is reached, prices will quickly decline. That said, even 2 mb/d of new supply will not quickly balance the market, which is hundreds of millions of barrels from equilibrium, but they could reverse the current bullish sentiment.
Additionally, the market has priced in a loss of 3 mb/d of Russian oil supplies, an amount that the IEA speculated could be off the market as of May but which now appears likely to be the upper limit. Recent news describes the Russians finding new buyers (mostly in Asia) and their exports might be reduced by only 1 mb/d from this point. Once that becomes clearer, there is likely to be a dip in prices, perhaps $5=10 for crude. Watch for the release of the next IEA Oil Market Report on June 15th with new estimates of losses.
U.S. oil production is expected to increase by more than 1 mb/d this year and would be a major contributor to an improving market balance. At present, the EIA estimates that U.S. oil production is 900 tb/d above the same time last year, meaning that it would have to increase another 500 tb/d or more the rest of the year to reach the projected levels. Tight markets for materiel and personnel could hinder this, which would be at least moderately bullish. Rising rig rates followed by higher production estimates would be bearish in the longer term, but obviously if the numbers fall short of current expectations, prices would be supported.
Inventory: The embargoes, official and otherwise, on Russian oil translate into a dislocation of supply streams and an increase in stocks at sea, as well as some in onshore storage outside the OECD. That oil cannot be easily measured and while OECD onshore inventories are extremely low, should they begin to increase, it would signal that the global market is returning to equilibrium. However, OECD data—reported by the IEA—tends to lag by a couple months and only covers about half the world’s oil industry. A better indicator is the U.S. inventory data, which are reported on a weekly basis and serve as an indirect indicator of non-U.S. stocks. U.S. oil exports, which are only estimated from previous year’s data in the Weekly Petroleum Statistic Report, are partly the result of the global oil balance, meaning that if U.S. inventories begin to rise, there is less pressure for exports.
Two financial indicators should prove very useful as early warning indicators of a market moving towards balance. The first is the degree of backwardation in the market, or the premium paid for prompt supplies versus those in the future. The figure below shows the difference between the first and fourth month contracts which is the premium for prompt barrels, in other words, an analogue for the tightness in the physical market. A decline will signal that inventories are building well in advance of the reported data.
Backwardation for WTI ($/bbl)
The second is the spread between Brent and WTI, shown in the figure below. The larger the spread, the tighter the non-U.S. market and the more likely U.S. crude will go looking for overseas buyers, which keeps U.S. inventories low. When that declines from the currently-elevated level, U.S. oil inventories should begin rising, which will be an indirect signal that the global market tightness is ebbing.
Differential between Brent and WTI ($/bbl)
Clearly, much depends on geopolitical developments, including the war in Ukraine and sanctions on Iran and Venezuela. But also, the three sanctioned oil producers will likely be increasing exports as they work around the sanctions through various means (hint: traders). The worst of the geopolitical news is now out with the announcement of European oil sanctions to be phased in, and with the passing of Memorial Day in the U.S., worries about the summer driving season should peak. Economic news seems certain to worsen over the next few months and higher non-OPEC production should see inventories rising through the end of the year.
That said, I have been wrong before and no doubt will be again. But the current price spike is clearly driven by transient developments which are much more likely to ease from this point than to worsen. My article, “Crude oil price volatility likely to drop absent policy shift,” in the February 6 Oil & Gas Journal (link below) describes the various elements causing price volatility and where (I think) they will go in the long-term.
