As if some of the main actors on the stage of the global economy were reading from the same script in the middle of last week. Oil prices hit multi-year highs on Wednesday due to the combination of expected tighter supply for the remainder of the year and the astronomical rise in worldwide natural gas and LNG prices. The sentiment suddenly soured on Wednesday afternoon when the Russian president hinted at increasing supply to Europe to ease the energy crunch and the US energy minister made it clear that her administration will use every tool available to tame rising prices, including the release of SPR barrels or even the temporarily re-introduction of crude oil export ban. Add to those the persistent concerns about possible US default and government shutdown and the stampede towards the exit from the risk-asset arena became intense.
Nerves were calmed 24 hours later. It was not entirely clear what Vladimir Putin’s intention were by hinting at top up supplies from Russia. Although gas prices pulled back, even at these levels they are high enough to guarantee additional oil demand as the gas-to-oil switch economics are still alive and well. In an irritating communication blunder the US Department of Energy went back and forth on claims of SPR release and the market was quick to discount this possibility, at least for the time being. The US Congress struck a deal on Thursday night to extend the debt ceiling into December averting the immediate government closure and triggering an eagerly awaited stock market rally. Oil gained around 4% on the week and major stock indices also edged higher.
Conventional wisdom and common sense dictate that the fairest price of a commodity or product is always determined by supply and demand – let them be physical or speculative. It is hard to argue against this approach therefore one must conclude that Brent, for example, currently above $82/bbl is the fairest price. A more pressing question is what the “fair” price will be in months to come. There are several indicators that suggest protracted strength, on one hand, but some would imply that the top cannot be far away, on the other.
Advocates of prolonged elevated prices would point to the rally to $148/bbl in 2008 or to the $90-$130/bbl range between 2011 and 2014 – it proves that the world can live with $100+ prices. Better yet, they would emphasize that the amount of money currently spent on oil, as its share of the global GDP, does not particularly imply that the top is nearby. This percentage was around 3.7% and 3.6% in 2008 and 2011. To use the latter as an example it is calculated by taking the global GDP for 2011 ($100 trillion) and divide it by the average Brent price ($110.91) times global demand (89.07 mbpd*365 days). This ratio for this year is 1.58%, less than half of what was seen 10 years ago. In other words, the world spends considerably less on oil than 10 or 13 years ago, ergo consumption of oil is subdued even if one takes into account the transition from oil to renewables is under way.
Secondly, OECD inventories might also justify price resilience if you believe that they are highly correlated to oil prices. We will have an update on the latest supply-demand balance and oil inventories this week when the three forecasters release their latest estimates but judging by the previous set of data OECD oil inventories could easily fall below 2.8 billion bbls, especially that OPEC refused to raise production by more than 400,000 bpd for November. In the past, inventories below this level have corresponded to a Brent price in excess of $90/bbl.
In the bear corner are those who believe that all of the above is taken out of context because the pandemic, the subsequent economic recovery and the rise in demand (both aggregate and oil) have upended relationships that served the analyst well in the past. We are living in literally unprecedented times and all one has to do is to look at galloping prices in every segment of the economy partially triggered by the increase in consumption but also due to supply chain bottlenecks. Rising inflation is unsustainable and policy makers will have to act soon. Withdrawing monetary and fiscal stimuli and raising interest rates (as some central banks have already done) will put a break on demand growth and would limit any upside potential in equites and oil. The signs of struggling growth are there for everyone to see. The dollar fulfils its safe have function and it is very strong. Its index against six major currencies is hovering around the highest level for a year. Bonds are getting sold off and yields are going higher, another indication about the growing concerns of inflation. The US 3-year yield reached its highest level since March last year on Friday. The fact that oil remained resilient in the face of economic adversity is nothing but a bubble that will burst soon.
And lest we forget politics. Consuming nations finds the $80+ price level basis Brent way too high. The world’s biggest oil consumer, the US, floats ideas every now and again how to take the wind out of the sail of the current rally. These include pressure on OPEC, SPR release and even crude oil export ban. Retail domestic gasoline price, the main measure of the approval rating of the president, were above $4/gallon during before the 2008 financial crisis. They are nearly $1/gallon below the 2008 peak but anything above $3/gallon clearly jeopardizes the chances of Democrats ahead of the midterm elections next year. Letting the market set prices would help keep one of the main campaign promises of the current administration firmly on track -to hasten the transition from fossil fuel to renewables- but short-term political interests unambiguously trump climate concerns.
So where are oil prices heading? A straightforward question with a complex answer. To try and simplify the latter there is a strong case to conclude that depleting stocks, OPEC discipline and the ongoing energy crunch will provide solid price support in the next three months. And in 2022? The dilemma is whether inflation-induced growth concerns and the withdrawal of economic support will have an adverse impact on oil demand and therefore on prices or the self-fulfilling prophecy of “hedge-against-inflation-partly-caused-by-expensive-oil” will guarantee continuous strength. The picture beyond 2021 is still blurred.