The only bullish element of yesterday’s trading, OPEC’s struggle to increase production meaningfully, went unnoticed. The producer group, the latest Reuters survey showed, pumped 28.98 mbpd in July, up 310,000 bpd on the month. Those with quotas increased production by 240,000 bpd, 1.28 mbpd below the maximum allowed, reaching a compliance of 418%. Such a dismal reading is a proof that OPEC is unable or unwilling to swing as much as consuming nations would like. Underproduction usually lays the foundation of an oil price rally. Yesterday, however, the focus was firmly on economic matters, on global factory activities, to be precise.

Global manufacturing spectacularly suffered from the combination of Covid curbs in China and diminishing worldwide consumer demand due to high inflation. Chinese factory activity unexpectedly contracted in July, according to official data whilst the manufacturing sector also shrank in the euro zone last month, S&P Global’s final PMI showed. In the US the sector expanded at its slowest pace since June 2020. The ISM put the manufacturing index at 52.8%. Needless to say, that these readings did nothing to mitigate the fears of recession.

Negative demand prospects have been offset by supply constraints in the past few months because of actual or perceived scarce availability of oil, which includes an EU ban on Russian oil sales. The plan is to deprive Russia of its main source of revenue but recent amendments imply that the EU now believes the proposal in its original form will do more harm than good for the instigator. Probably this is the reason why, as reported in the Financial Times, Brussels revised some of its curbs and now would allow European buyers to pay Russian counterparts “if those transactions are strictly necessary”. These measures, the EU argues, are vital to alleviate worries about energy security.

The net result was a sizeable fall in oil, which took the price of WTI nearly $5/bbl lower and Brent finished the day close to $4/bbl down. The next catalyst, up or down, we shall see tomorrow, is the upcoming OPEC+ meeting where Saudi Arabia and its allies will have to decide whether to heed Joe Biden’s request and raise production or show solidarity towards Russia by staying put and reserve existing spare capacity in case prices rally considerably again, something that is implausible in the present economic climate.

The standstill of everything

The recovery from the pandemic, which started in March-April 2020 was the beginning of the “rally of everything”. Central banks’ efforts together with government help created healthy aggregate demand and risk assets started their long journey north. Monetary and fiscal policies were so successful that appetite for relatively unknown stocks, the likes of a video game retailer GameStop and others, increased 20-30-fold in the space of a few weeks at the beginning of 2021. Oil was obviously a part of this protracted buying spree. After the devastating price war between Russia and Saudi Arabia in the first quarter of 2020 members quickly buried the hatchet, came to an agreement and decided to take 9.7 mbpd of oil off the market and to gradually release it back over a two-year period.

As the global economy roared back to life rising oil demand coupled with the effective market management of the OPEC+ producer group oil significantly outperformed equities. Brent rallied 269% between April 2020 and January 2022. During the same period the S&P 500 Energy Index (Total Return) jumped 137%. The US shale industry had also undergone a spectacular revival. The share price of Pioneer Natural Resources, for example, returned more than 200% to investors during those months despite capital discipline having been widely introduced in the sector. It was noticeable that the S&P 500 equity index “only” strengthened 79% 2Q 2020-to-January 2022. The comparatively sluggish performance implied that oil investors remained upbeat on tight oil balance and stuttering production growth. They were confident that the first signs of inflation that emerged sometime in the middle of last year would not have a tangible negative impact on global oil inventories and the oil market would remain supported.

Then Russian troops invaded parts of Ukraine. The initial reaction was one of shock and disbelief, which saw Brent rally close to $140/bbl while stock markets came under noticeable pressure until the middle of March. International wars always pose a risk to the global economy but given that one of the warring parties happens to be a significant oil exporter the oil price rally was anything but dubious. Oil and equities have de-coupled. As measured by the ratio between the S&P 500 equity index and Brent became very expensive. This differential fell from over 60 at the end of last year to nearly 30 by mid-June.

In the past 6 weeks, however, oil started to give up some of the grounds it had gained against equities after February, and it has also come to a standstill. Firstly, the aforementioned ratio has retreated to 41 – sign of relative strength of stocks against oil. Secondly, oil is struggling to go anywhere near to the peaks observed in the first half of March. In fact, after yesterday’s slump front-month Brent has lost 28% of its value from the $139.13/bbl summit. It is another indication that attention is shifting from supply to economic and demand considerations and unless oil is weaponized buyers will keep shying away at slightly higher levels.

Paralyzed Urals market

Talking about standstills, the main crude oil export blend of Russia is losing its sparkle. Of course, it is still being bought and sold in the international markets, chiefly because Russian-friendly importers are more than happy to take full advantage of heavily discounted levels. Nonetheless, it is getting ever more difficult for Price Reporting Agencies (PRAs) to put a fair value on it. S&P Global Platts has valued Ural’s discount to benchmark Brent either side of $40/bbl since the war broke out. It has also consistently maintained a differential of 30 cents/bbl between NWE and Mediterranean cargoes, an obvious sign of a broken market.

In the absence of functioning Urals market because of lack of transparent trades another PRA, Argus has decided to replace Russian Urals with a new index, called Brent Sour index. In a podcast published on Argus’s website the PRA argues that the sanctions on Russian oil sales left a hole in supply and price identification and this gap needs to be filled. Argus decided to swap sweeter grades, Oseberg, Ekofisk and Troll, out of its Brent basket and replace them with Johan Sverdrup, Grane and Flotta Gold, all sourer grades. Brent and Forties stayed to ensure liquidity and the daily price will be set by the lowest grade in the basket. Argus believes its new index will offer a fair assessment for sour grades in Europe and they do not expect Urals to return as a reliable marker for heavy and sour grades in the medium-term future.