You could be forgiven thinking that, just by looking at the settlement prices, Iran has managed to strike a deal with Western powers, and they will resume crude oil exports this week and/or resurgent coronavirus has forced countries to re-introduce mobility restrictions, which significantly hampers oil demand growth. The truth, however, is that outright prices went into freefall, time spreads crashed, and bulls were obliterated because stubbornly high consumer prices have raised the odds of interest rate hikes and consequently it was the financial supply that increased meaningfully yesterday as money managers got rid of part of their length, especially on the front end.
US consumer prices rose by 6.2% last month, at the fastest pace in 30 years. The month-on-month increase was 0.9%. The surge was the result of the price rise in energy and the increase in the cost for food, used and new vehicles. The US president unequivocally put the blame on energy and has reportedly instructed the National Economic Council to examine ways to reduce energy costs and the Federal Trade Commission to increase the fight against price manipulation.
The relentless increase in consumer prices will pile further pressure on the Federal Reserve to raise interest rates, the thinking goes. The resultant dollar strength and the sell-off in Treasury bonds have also contributed to the bull stampede towards the exit.
Rising consumer and producer prices are, indeed, valid concerns, and they could act as a break on economic growth thus hurting oil demand. These concerns, however, do not change the current physical oil balance. The rest of the year is expected to remain tight. As demonstrated in the latest weekly US stock data, demand is still flirting with the 20 mbpd mark and commercial oil stocks, which declined 1.2 million bbls last week are 43.6 million bbls lower than the 5-year average. If the recent price strength is fundamentally justified and yesterday’s sharp move lower was, in fact, speculative in nature then bottom pickers ought to emerge in the not-so-distant future.
Prevalent optimism could come to a temporary halt
Depending on which side you are on you will conclude that the oil market is audaciously or understandably resilient. Despite the occasional and temporary pullbacks, the one we saw last week, or yesterday’s retracement oil prices are not far off from their highest levels in several years. The voices of those who expect this strength continue unabated sound very confident. To attempt to establish whether the faith in protracted oil price strength is vindicated it is worth taking stocks of the headwinds the market faces together with the tailwinds that supports it.
In the former category the fact that the fight against the coronavirus is ongoing cannot be ignored. Total cases have surpassed the 250 million milestone whilst death toll is now over 5 million. As winter approaches in the northern hemisphere surge in cases and therefore the re-imposition of assorted restrictions are not only anticipated but are already happening. This, in turn, could act as a break on economic growth. Another factor that could influence investors’ mindset is China. Ever since Cold War II got under way during Donald Trump’s presidency, China, the second biggest economy in the world has become increasingly inward-looking in its quest to global economic and political domination. The change in attitude could inevitably and negatively affect the engine room of the global economy.
As the world is gradually recovering from the health crisis the growth in aggregate demand coupled with serious issues in supply chains all over the world are pushing producer and consumer prices to levels not seen for a long time – just see yesterday’s US CPI data discussed above. The US central bank has already started withdrawing monetary support in its effort to tame inflation. Several other of its peers have raised interest rates. The Fed and the Bank of England have resisted to calls to cool the price rise by increasing rates and the ECB does not recognize the necessity of raising rates either as it believes that prices will stabilize once supply chain problems are mitigated. Nonetheless, bond yields are edging higher and inflation concerns can also temper sentiment and expectations.
Finally, Tuesday’s release of the Short-Term Energy Outlook from the EIA served us with a timely reminder that the period of relentless stock depletion could come to a halt when the New Year gets underway. The call on OPEC will drop from 28.62 mbpd in 2H 2021 to 27.87 mbpd in 1H 2022 whilst the OPEC+ group is likely to keep increasing its production level by 400,000 bpd a month. There is a healthy chance that global supply will exceed global demand in the first half of next year.
Whilst all of the above are probably valid arguments bulls are convinced that any dip will be brief, just like in the past. After all, global and OECD oil inventories are at historically low levels and the global economy is on the mend. All one needs to do is just to look at the performance of different stock indices. Attractive corporate results are another sign of the economic recovery that has been underpinning global oil demand growth. It is partly the result of successful vaccination programmes, and this growth is not in jeopardy even if sporadic flare ups in infections might suggest otherwise. Disciplined supply management of the OPEC+ group helps oil inventories drawing. Referring back to Tuesday’s monthly EIA report, OECD commercial oil stocks are forecast to drop down to 2.75 billion bbls by the end of this year, which equals around 60 days of forward cover.
Additionally, the oil market is undergoing a structural change where the growth in oil demand will considerably exceed the growth in supply (not just in oil but in other commodities, too) leading to the next commodity super cycle that can last several years. The main proponent of this view is the influential investment bank, Goldman Sachs. Given the significant underinvestment in the upstream sector and the perceived continuous reliance on fossil fuel, including oil, predicted supply deficit should, indeed, provide long-lasting support for oil prices. Because of the seasonal drop in oil demand in the first half of 2022 the price rise might come to a temporary halt soon, but this will not undermine the belief that painful price spikes are lying ahead.