Oil Marginally Rebounds After Hitting 15-Month Low, but Looming Economic Risks Counter China’s Recovery Optimism
Oil snapped a two-week losing streak. The May ’23 WTI contract gained $2.52 on the week to finish at $69.26/Bbl. The ongoing banking crisis caused oil to break out of the $10 trading range it had been stuck in for about three months, driving crude to a 15-month low. However, oil bulls remain optimistic due to China's demand recovery despite concerns about a mounting economic risk.
After Wednesday's 25 basis-point interest rate hike, Fed Chair Jerome Powell cautioned that there might be more tightening in the future and that there won't be any rate cuts this year. He also warned that if the banking industry experiences stress, it could lead to a credit crunch with significant implications for the already slowing U.S. economy.
Russia announced Tuesday that it would maintain its 0.5 MMBbl/d cut in oil production through June 2023. Russian Deputy Prime Minister Novak cited embargoes and attempts to cap Russian oil prices. The cut is in addition to OPEC+'s supply reduction agreement, and ministerial meetings on market conditions are scheduled for April 3.
Additionally, the U.S. may not refill its Strategic Petroleum Reserve (SPR) at the target price range of $67-$70/Bbl this year due to maintenance and mandated crude sales, according to Energy Secretary Jennifer Granholm. The SPR currently holds its lowest level of oil since 1983 at 372 MMBbl.
On balance, AEGIS believes that price risk is skewed to the upside in 2023 due to supply shortfalls and upside demand risks. AEGIS acknowledges that global economic concerns are real and advises a modestly bullish scenario where there is only moderate undersupply but low inventories of oil and products. Furthermore, low OPEC spare capacity could lead to slight scarcity and more leverage on price than usual. This vulnerability makes the market susceptible to upsets in the daily flow of oil supply.
AEGIS hedging recommendations for crude oil remain costless collars for 2023 and 2024. A collar would set a price floor but allow for more upside participation, compared to a swap if prices realize higher. The upside exposure afforded by the structure makes it very popular among our clients in bullish markets.
To see details on factors we believe are affecting oil prices and trade recommendations, click the "Read More" button on the Factor Matrix section in the AEGIS Research Module.
Crude Oil Factors
Geopolitical Risk Premium. (Bullish, Surprise) We decided to add this new factor, considering the recent turmoil hitting several countries in the eastern hemisphere. Most headlines are dominated by the Russian invasion of Ukraine, which has been the driving factor behind the prices. The European Union and G7 approved the eighth set of sanctions and a price cap on Russian oil imports, which came into effect on December 5. 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. Escalating tensions in the eastern hemisphere including the alliance of Saudi Arabia and Iran mediated by China along with reports of potential Saudi-Syria ties, which could further impact the region's stability might also act as a risk premium on oil prices.
Trade Flows. (Bearish, Priced In) April '23 WTI gained $2.52 to settle at $69.26/Bbl this week. Prices fell this week despite no fundamental drivers. Oil prices tracked equity markets lower, as renewed worries over the U.S. and European banking sectors revived fears of a credit squeeze and an economic downturn. AEGIS also notes that the recent movement in prices could be driven by the price trend (technical selling) 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 selloff in the crude market is attributed to major funds/firms liquidating.
Iran. (Bearish, Surprise) The Iran nuclear deal negotiations concluded on August 8 after 16 months. U.S. Secretary of State Antony Blinken said that an agreement in the near future is "unlikely." If an agreement is reached, the nation may increase output by nearly 1 MMBbl/d, perhaps starting in phases beginning in 2023. The possibility of ending or reducing Iran sanctions poses a downside risk to oil prices. This is one of the bearish non-economic factors that could pressure oil prices in 2023.
U.S. - China Tensions. (Bearish, Surprise) The tensions between the U.S. and China have been fueled by a range of issues, including trade imbalances, technology competition, human rights concerns, military tensions, and ideological differences. Both countries have accused each other of unfair practices while expressing concern about the other's actions. The latest trade tensions stem from the U.S.’s effort to clamp down on China’s access to critical semiconductor technology and to impose export restrictions.
According to a Goldman Sachs survey at their Global Macro Conference, ‘U.S. – China tensions’ was the most concerning factor to many investors this year. Escalated tensions between the U.S. and China could potentially reduce demand due to trade barriers and slower economic growth.
Russian Supply. (Bullish, Surprise) The Russian invasion of Ukraine has not yet resulted in a major shortage of oil on the market. 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. Additionally, the ban on Russian fuel exports came into effect on February 5. However, there is little corroborating data yet to show Russian supply loss. Russia’s resilience to Western sanctions might become less bullish in 2023 if Russian crude exports remain steady.
Oil/Product Inventories. (Bullish, Priced In) Crude and refined product inventories in both the U.S. and abroad are extremely low. Crude data is usually on a several-month lag. IEA data shows that OECD inventories were 16.6 MMBbl below the five-year average in December. The oil market has likely remained in a 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 9% 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.
Supply Chain. (Bullish, Priced In) U.S. producers are struggling with supply chain disruptions, such as a shortage of workers, and equipment, a scarcity of sand for fracking operations, and high metals prices, to take advantage of increased global demand and high oil prices. These constraints could influence driving the prices up.
Economic Slowdown. (Bearish, Mostly Priced In) Turmoil in the banking sector amplified fears that aggressive monetary tightening by the Federal Reserve and other central banks has set the stage for a sharp economic downturn this week. The failure of Silicon Valley Bank (SVB) and trouble at Credit Suisse, compounded by technical selling, triggered a three-day rout last week that sent prices to the lowest since December 2021.
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 and are forecasting it would fall by 0.9% in 2023. 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. U.S. CPI, an indicator of household goods inflation, showed the annual inflation rate fell for the seventh consecutive month to 6.0% from 6.4%, its lowest level in more than a year. Fed Chair Jerome Powell advised that further tightening may be in store following Wednesday’s 25 basis-point interest rate hike and added that rates won’t be cut this year.
OPEC+ Quotas. (Bullish, Slightly Priced-In) The OPEC+ (OPEC plus collaborating countries) “cut” announced on October 5 was a reduction of their production quotas of 2 MMBbl/d, or roughly 2% of global consumption, in an effort to stop the decline in oil prices. Saudi Arabia said that unless the market changes, the supply curbs will be in place through December 2023. AEGIS notes that even if the quota target is reduced, the actual production loss may be much smaller (1.0-1.1 MMBbl/d). Many OPEC+ members, including Russia, are already vastly underproducing compared to their quotas. This policy of quotas, which had been in place since mid-2021, has been revised in light of a decline in Russian output due to additional sanctions. Many analysts question how much spare capacity the group really has left. Several countries, such as Angola and Nigeria, have underperformed relative to their quotas. These shortfalls have exacerbated recent market tightness. OPEC+ members attributed this week's price weakness to financial drivers rather than any supply and demand imbalance, adding that they expected the market to stabilize.
China Growth. (Bullish, Surprise) 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. When the country completely emerges from the lockdowns, its oil demand is expected to rise, putting extra strain on a market that has already tightened dramatically since Russia invaded Ukraine. Chinese oil consumption is expected to hit a record high this year. According to the IEA, Chinese demand will increase by 0.9 MMBbl/d in 2023. China’s demand is important as it is nearly half of the global demand growth in 2023, which the market expects to grow anywhere from 1.7 to 2.1 MMBbl/d. China's manufacturing activity expanded at the fastest pace in more than a decade in February, signaling a further recovery in Chinese demand.
USD. (Bearish, Priced In) The U.S. dollar's value surged to its highest in nearly three months last week before weakening relatively and surging again at the end of this week. The movement in DXY was one of the bearish factors affecting crude prices this week. A strong dollar can cause foreign buyers of dollar-denominated commodities to pay more for the same amount of goods. Fed Chairman Jerome Powell provided hawkish guidance and reiterated that the bank might raise interest rates more than expected, but he said that a decision hadn’t been taken for the March meeting.
Non-OPEC Production. (Bearish, Surprise) 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. EIA forecasts the 2023 non-OPEC production to increase by 0.5 MMBbl/d.
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