Oil Ends Week Higher Amid Ongoing Geopolitical Tensions, Fading Rate Cut Hopes Cap Gains
Oil prices experienced a volatile week, with June ’24 WTI hitting as low as $80.88/Bbl on Tuesday before finishing higher at $83.85/Bbl on Friday, posting a weekly gain of $1.63/Bbl. The U.S. GDP growing at only 1.6% compared to the expected 2.4% in Q1 2024 has further fueled fears of an economic slowdown, weighing on both equities and oil prices this week.
Furthermore, the Fed’s preferred inflation measure, the PCE, rose 0.3% in March and 2.8% Y-o-Y, remaining unchanged from February. Three straight months of sticky inflation data indicate that progress toward the Fed's 2% target may have stalled, possibly prompting the Fed to maintain higher rates for longer.
Prices, however, found support as Israel stepped up airstrikes on Gaza’s Rafah and prepared for a potential all-out war with Hezbollah. Meanwhile, the prompt spreads (M1-M2) for WTI and Brent rose to 73c and $1.30, respectively, up from 64c and 78c last week. A steeper or more backwardated curve signals tightness in the market, and this encourages withdrawals from storage.
In mid-April, when WTI was trading around $88/Bbl, a geopolitical risk premium of $5-10/Bbl was estimated to be priced in due to the Middle East tensions. This premium appears to have eased recently following Israel's limited retaliation against Iran last week.
AEGIS believes that oil prices are now more fundamentally priced, with part of the war premium having been removed. As 2Q progresses, the market may start looking forward more to supply and demand balances. AEGIS maintains a bullish outlook on the curve as OPEC+ supply cuts continue to support the market amid declining inventories.
Additionally, despite President Biden's new and expanded sanctions targeting Iran's oil sector this week, analysts expect minimal impact on Iranian oil exports (1.5 MMBbl/d), largely due to potential lenient enforcement and possible waivers by the administration to avoid oil price spikes before the 2024 elections.
Crude Oil Factors
Geopolitical Risk Premium. (Bullish, Priced In) Considering the turmoil hitting several countries in the eastern hemisphere, we decided to add this factor. Since October 7, most headlines have been dominated by the escalated conflict between Hamas and Israel. The knowledge that the Iranian government has backed Hamas leads many to believe action could be taken against Iran.
Cease-fire prospects in the Israel-Hamas conflict dimmed as Israel geared up for operations in southern Gaza amidst escalating tensions in the region. Netanyahu's insistence on "total victory" over a ceasefire, combined with Iraq's threat to withdraw support from the U.S.-led coalition, further complicated matters. Concurrently, the
Israel retaliated against Iran’s drone and missile attack last weekend with what appeared to be a limited strike on Iran. The extent and impact of the Israeli strike appeared to be minimal as Iranian state media downplayed the incident, and Tehran indicated it had no plans for retaliation.
Furthermore, last year's Russian invasion of Ukraine continues to weigh on prices. The EU and G7 approved the eighth set of sanctions and a price cap on Russian oil imports, which came into effect on December 5, 2023. The EU and G7 agreed upon a $60/Bbl price cap on Russian crude, which will be reviewed bi-monthly. The EU implemented a similar price cap mechanism on Russia's fuel exports on February 5.
Trade Flows. (Bullish, Priced In) Traders stepping back into speculative positions on potential conflict-driven rallies has increased volatility and is exerting upward pressure on oil prices. Oil prices tracked equity markets since March 2023 as renewed worries over the U.S. and European banking sectors subsided. AEGIS also notes that the recent movement in prices could be driven by the price trend (technical selling or buying) itself rather than the fundamentals. We see that trade flows have been affecting the price action in the commodity markets for the past few weeks, as the recent movements in the crude market are partially attributed to algorithmic buying. Heightened geopolitical tensions have prompted money managers to pile into oil as indicators improve, positioning Brent at its most bullish level in more than a year and WTI at its highest in about five months.
Russian Supply. (Bullish, Priced In) Russia has halted gasoline exports from March through November 2023 to control rising domestic fuel prices. Also, Moscow has previously pledged to cut production by 0.5 MMBbl/d from March through 2024. Russia's total petroleum exports are estimated to be around 7 MMBbl/d, and the absence of even a portion of this supply, given that Russia is the world's third-largest supplier of oil, would be a significant influence in driving up prices. China and India remain to be the biggest buyers of Russian crude. The sanctions and price cap are estimated to risk 0.5 to 1.5 MMBbl/d of Russian oil production.
Since the beginning of 2024, Ukrainian drone attacks have significantly affected Russian oil refineries. The attacks reduced Russian oil refinery output by 12% so far in March. These incidents are part of a series of strikes targeting Russian energy infrastructure, including attacks on oil depots and refineries in various regions, contributing to disruptions in Russia's ability to export oil products. Additionally, Russia has adhered to its pledge and curbed exports by 0.49 MMBbl/d in January.
OPEC Market Share War. (Bearish, Surprise) The possibility exists, albeit a small one, that should OPEC's efforts to bolster oil prices through production cuts prove unsuccessful, the cartel could potentially flood the market with additional barrels as a strategy to reset.
Oil/Product Inventories. (Bullish, Priced In) Crude and refined product inventories in both the U.S. and abroad are low. Crude data is usually on a several-month lag. According to the April IEA report, OECD inventories were nearly 53 MMBbl below the five-year average as of February. The oil market has likely remained in a slight supply deficit since then, so inventories could be lower now, as evidenced by the backwardation in the forward curve. Additionally, volatility will likely be heightened with inventory levels at inadequate levels to serve as a "shock absorber" for prices. Distillate fuel inventories in the U.S. are 12% below the five-year average for this time of year. Meanwhile, exports continue to be high as refiners attempt to address global shortages brought on by the pandemic's quick recovery and the disruptions caused by Russia's invasion of Ukraine.
Economic Slowdown. (Bearish, Mostly Priced In) The U.S. GDP growth rate of just 1.6% in Q1 2024, significantly below the anticipated 2.4%, has heightened concerns about an economic slowdown, negatively impacting both equity and oil markets this week. Higher interest rates have caused concern for demand throughout 2023. Threats to global GDP impact oil demand growth projections. Higher global energy prices might increase the potential for an economic slowdown. Macroeconomic uncertainties could pressure oil demand and, therefore, oil prices in 2023. According to the EIA, U.S. real GDP declined by 2.8% in 2020, and they estimate U.S. GDP increased by 5.9% in 2021. They estimate GDP has risen by 2.1% in 2022. 2.5% in 2023 and are forecasting it would rise by 2.6% in 2024. While that doesn't sound all too bad, the main takeaway is that crude oil demand growth would likely slow with GDP, and if supply growth outpaces demand growth, then you would find yourself in a structurally weaker market. Some analysts expect the Federal Reserve to cut interest rates in 2H 2024. Lower interest rates cut consumer borrowing costs, which can boost economic growth and oil demand.
OPEC+ Quotas. (Bullish, Priced In) On March 3, OPEC+ extended their 2.2 MMBbl/d production cuts through June, aligning with market expectations amidst increasing non-OPEC supply and uncertain global demand. Saudi Arabia is extending its voluntary 1 MMBbl/d cut, keeping output at 9 MMBbl/d. Additionally, Russia's cut of 0.47 MMBbl/d in Q2 could tighten the Urals supply.
AEGIS notes that the global crude market would quickly build inventories without OPEC's support in reducing supply. Furthermore, IEA now projects a deficit of 0.32 MMBbl/d, a stark contrast to its previous forecast of a 0.8 MMBbl/d oversupply and consequent inventory builds. This adjustment stems from the first-time inclusion of expected OPEC+ production cuts extending through the year's end, a view that diverges from OPEC's own announcement of cuts lasting until 2Q 2024.
China Demand. (Bullish, Partly Priced In) China's oil demand has been severely affected in 2022 by strict COVID-19 control measures. Reduced mobility has hindered economic activity and, therefore, consumption. China eased its Covid restrictions in early December 2022 and announced a slew of economic measures to boost its economy. As the country completely emerged from the lockdowns, its oil demand was expected to rise, putting extra strain on a market that has already tightened dramatically since Russia invaded Ukraine. However, the pace of Chinese demand growth has been slow compared to what the market had expected. Chinese oil consumption is expected to hit a record high this year. According to the IEA, Chinese demand rose by 1.7 MMBbl/d in 2023 and is expected to increase by 0.7 MMBbl/d in 2024. China’s demand is important as it is nearly half of the global demand growth in 2024, which the market expects to grow by about 1.2 MMBbl/d. Manufacturing activity in March expanded for the first time in six months, according to an official factory survey.
USD/Fed (Bearish, Priced In) The Fed’s preferred inflation measure, the PCE, rose 0.3% in March and 2.8% Y-o-Y, remaining unchanged from February. Three straight months of sticky inflation data indicate that progress toward the Fed's 2% target may have stalled, possibly prompting the Fed to maintain higher rates for longer. However the US dollar found support from strong US jobs report and strengthened. This, in turn, makes oil, priced in USD, more expensive for holders of other currencies, likely not supporting demand.
Non-OPEC Production. (Bearish, Priced-In) Many prominent research groups (EIA, IEA, OPEC) think non-OPEC production, dominated by the U.S., will increase in 2023. If these forecasts come to fruition, it would have a slightly bearish impact on oil prices if the market were otherwise well-supplied. IEA forecasts the 2024 non-OPEC production to increase by 1.6 MMBbl/d.
OPEC Reversal/Compliance. (Bearish, Surprise) The new voluntary OPEC+ production cuts put member nations' adherence to quotas under scrutiny. Any deviation, such as halting, reversing, or exceeding their quotas, could end up being one of the surprise bearish factors weighing on the market.
China Inventories. (Bearish, Mostly Surprise) China has an inventory capacity of 1 -1.2 Billion barrels, and inventories are currently around 900 MMBbl as of January, according to Vortexa. Over the first eight months of 2023, China accumulated about 130 MMBbl in its oil inventories, giving it considerable flexibility in its import decisions. Since August, China has been destocking, withdrawing approximately 100 million barrels. If prices remain range-bound or relatively low, China might start restocking, preparing for times when refiners, responding to high global prices, opt to reduce imports and draw more from these stockpiles. This could exert downward pressure on global crude prices. Historically, China has reduced imports when crude prices surge; however, the market seems to be underestimating this potential impact on crude demand.
China-Taiwan Conflict. (Bearish, Surprise) Should the China-Taiwan conflict escalate, it may lead to increased sanctions on China, the world's largest oil consumer, and pose a significant bearish risk to oil prices. These sanctions could substantially weigh on China's oil demand. Beyond the oil market, such sanctions would have broader repercussions, disrupting international trade, undermining global economic stability, and straining geopolitical relations. The impacts would be felt across global supply chains and in countries reliant on economic ties with China.
Ceasefire(s). (Bearish, Surprise) The crude oil market is currently seeing prices rally partly due to the geopolitical risk premiums associated with three major conflicts: the Russia-Ukraine war, the ongoing Israel-Hamas hostilities, and the Houthi attacks on Red Sea shipping. These conflicts have significantly contributed to the uncertainty in the oil markets, pushing prices upward as market participants weigh the risks of supply disruptions and increased tensions.
However, there's an inherent risk that a ceasefire or de-escalation in any of these situations could lead to a sudden decrease in oil prices. This potential for headline risk could see prices adjust quickly if, for instance, Ukraine and Russia move towards peace, the Houthis halt their maritime assaults, or a ceasefire is brokered between Israel and Hamas, reducing the current geopolitical risk premium embedded in the price of oil.
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