Despite a decent and encouraging performance the week ended on a downbeat note because Friday’s US inflation figure triggered a stampede towards safe havens like the dollar or gold. The index of the world’s reserve currency strengthened nearly 0.9% on the day and gold advanced 1.26% higher. At the same time equities came under intense pressure. The MSCI World Equity Index fell 2.74% and the S&P 500 index 2.91% finishing a truly dismal week where it lost more than 5% of its value in what was its biggest weekly loss since the beginning of the year.
It has been noted regularly on the pages of this report that the oil market is primarily being driven by supply considerations, consequently fragile economic growth concerns, that are the result of global inflationary pressure or Covid curbs in China play only second fiddle when it comes to the formation of oil prices. Clearly, Friday’s price action and the follow-through selling seen this morning are the exceptions that prove the rule. Although every major oil futures contract, bar RBOB, registered decent weekly returns the unexpected reading of the CPI data had a profound negative, albeit possibly brief, impact on investors’ sentiment. The two crude oil contracts settled roughly $1/bbl lower and RBOB fell more than 10 cents/gallon on Friday and are shedding further values today. (The present price fall is exacerbated by warnings of a “ferocious” spread of the Covid virus in Beijing by officials casting doubt on immediate demand recovery.) It is, however, noteworthy that despite the considerable long-liquidation the front-end backwardation on both WTI and Brent is widening.
US consumer prices surged 1% in May compared to the previous month and the year-on-year rise was 8.6%, the steepest increase for 41 years. The report threw a spanner in the works of peak inflation advocates and raised fears that consumer prices might remain at elevated levels for some time forcing the US central bank to raise interest rates quicker than anticipated. Taming inflation by almost any mean necessary is now the single most important job of both fiscal and monetary policy makers and will come at the expense of economic growth, which would inevitably destroy oil demand further down line. The only, and possibly most relevant, question is when.
Higher but not much longer
Whether turning on the television, reading newspapers or talking to industry players the message has been the same: oil prices are prone to further rallies. Trading houses, investment banks and even bureaucrats agree that despite the recent strength the top is not in sight yet and the supply-demand balance will tighten as a result of disappearing Russian barrels. The CEO of Trafigura envisages $150/bbl this summer. Morgan Stanley expects Brent to pop up to $130/bbl by 3Q 2022. Goldman Sachs upped its Brent price forecast by $10/bbl and now forecasts $135/bbl Brent between 2H 2022 and 1H 2023. Citi believes that the tug-of-war between Iran and the US contributes to a bullish market. Barclays increased its Brent price forecast by $11/bbl for this year and by $23/bbl in 2023. The IEA warned of energy shortage in case of a cold winter and the UAE energy minister labelled the OPEC+ effort to increase output “not encouraging”. And then there are those who predict a super-cycle, high oil prices for the next decade and beyond because of significant underinvestment in past years.
Whether current oil prices are high or not depends on one’s view. One approach is to draw a comparison with the 2008 oil price rally or the protracted $100+ price level between 2011 and 2014. Brent is still well below the peak of $147.50/bbl seen in the middle of 2008. In fact, when adjusted to inflation today this price is over $200/bbl. During the period 2011-2014 front-month Brent averaged at $110.56/bbl ($135/bbl in today’s price) implying that the world was able to live with high prices for a prolonged period of time.
The message is that in real term prices are nowhere near the peak and because of the war in Ukraine, growth in global oil consumption and lack of meaningful spare production capacity no trend reversal is plausible in the foreseeable future. Differences between 2008 or 2011-2014 and 2022, nonetheless, flash warning signs. The major contrast between the then and now are products. Although crude prices are still well below the 2008 level and are around the 2011-2014 average current product prices are much higher than the peaks 14 years ago or during 2011-2014. For example, US all grades retail gasoline prices, that were $3.299/gallon in 2008 or $3.680/gallon in 2012 have averaged $4.059/gallon this year (EIA data) and rose to $5.004/gallon on Saturday, according to the AAA. Ultra-low sulphur diesel, which is currently at $5.703/gallon retails 50% and 44% above the 2008 and 2012 average. No wonder that consumer prices are ruthlessly march higher. Although the weight of the energy component is undeservedly low in the inflation basket, it is still one of the main causes of inflation; after all the other components are impacted by the price of energy.
These price levels are unsustainable. Pent-up demand, the result of post-Covid economic recovery could keep product consumption more than healthy through the summer. This is the first holiday period in three years where free travel is possible and it is manifested in chaotic airport scenes and resilient retail product prices across the developed world. Once the summer driving season is over the current optimism could reverse. There is a smorgasbord of reasons why it is reasonable to expect oil prices reach their peaks towards the end of 3Q or the beginning of 4Q: a.) demand growth, including that of gasoline, traditionally slows or turns after 3Q, b.) the OPEC+ deal expires at the end of 3Q and it might lead to increased production, c.) before the US midterm election the Biden administration could strike a deal with Iran, d.) Russian oil flow re-alignment should become clearer in a few months’ time making it more transparent removing a huge uncertainty from the supply side of the equation, e.) accelerating interest rate hikes might halt the increase in consumer prices and bring down inflation – inflation and oil prices positively correlate and e.) global refinery crude throughput is expected to rise from 79.4 mbpd in 2Q to 82 mbpd in 2H 2022 (IEA estimate) helping to alleviate product shortage. The current bull market should continue well into the summer but a descent from these summits might begin as the year draws to an end.