Financial markets, including oil futures, are complex adaptive systems. Just because we understand each component, we might not grasp the results of the system as a whole. Economists believe the reason being is that system-level outcome is greater than the sum of the components because market participants often interact in ways that predicting system-level effects is nigh to impossible.

The nature of the complex adaptive system was on full display last month. At times oil prices were nearly pushed over the precipice just because China registered 20-odd symptomatic Covid cases. At others, bulls were in full control despite falling equity markets and a resilient dollar implied significant demand destruction. Indeed, the interaction of the heterogeneous actors has often led to counter-intuitive reactions.

April was characterized by the battle between bearish economic/demand and bullish supply factors and both sides of the coin have been greatly influenced by the Ukrainian war. Due to the Russian aggression commodity prices in general are implausibly buoyant, which forces central banks all over the world to phase out monetary stimuli and increase interest rates. To make matters worse, the world’s second biggest economy, China, is unwilling to deviate from its zero-tolerance approach towards Covid flare-ups raising fears of growth setbacks.

The economy – demand concerns

Untamed inflation and lockdowns in several Chinese regions have inexorably resulted in downward revisions of economic growth forecasts. The value of goods and services are now only expected to expand by 3.6% worldwide, according to the IMF, down from 4.4% in January. Consequently, inflation should remain at an elevated level. The multilateral lender forecasts inflation to average 5.7% this year in advanced economies and 8.7% in emerging and developing markets. Hastening interest rate hikes will likely to be the answer to galloping prices denting aggregate demand. The MSCI Global Equity Index fell 8% last month. The Chinese stock market was also badly bruised as severe Covid-related restrictions are deemed to act as a brake on economic expansion. Both the service and the manufacturing sectors shrank in China last month. The Shanghai Composite Index settled 6% lower although it finished the month on an upbeat note as the country’s Politburo promised to support the economy. Nonetheless, fears of global slowdown have forced the world’s reserve currency, the dollar to match its 20-year peak last month. However, the fact that oil still managed to eke out respectable gains in April shows that the dominant factor in influencing oil prices has been supply and not demand – at least for now.

Supply – the price driver

On the supply side the simple question is how much Russian oil have has, is being and will be lost. The debate around Russian production and exports will not be settled irrevocably in the immediate future. What is interesting and even concerning is that the adversaries on both sides of the conflict are willing to use energy as a weapon, which lends a bullish backdrop to prices. Russia has already threatened to stop gas shipments to Poland and Bulgaria after reneging on long-term contracts and demanding rouble payment whilst the West and within that the EU are considering the introduction of a formal embargo on Russian oil sales although the latter’s intention is not as clear-cut as it seems. The oil consuming parties in the war are facing the prisoner’s dilemma where countries more reliant on Russian oil are keen to protect themselves whilst those less dependent on Russia are pushing for a full-scale boycott creating a less than optimal outcome, which would be to collectively deny Russia its main source of revenue. An agreement, however, is edging ever closer, hence the decent rally yesterday from the sell-off in the early part of the trading session.

As noted above oil prices registered their fifth consecutive monthly gains despite headwinds triggered by sluggish equities and the strong dollar. These headwinds were more than neutralized by the impact of Ukraine’s invasion on oil output. The crude oil futures contracts both edged higher in April, WTI by 6% and Brent by 4% including monthly rollovers. The monthly performance implies that however impressive the decision to release 240 million bbls from strategic IEA oil stocks was it could not be sufficient to mitigate, let alone offset, potential supply shortage. Firstly, OPEC might not be able or willing to satisfy the demand for its oil, which stands at 29.20 mbpd for 2Q-4Q 2022, with the group’s March production at 28.56 mbpd, secondary sources estimate. The latest Reuters survey showed an anaemic monthly growth of a mere 200,000 bpd in April for OPEC-10, 875,000 bpd below the ceiling, Secondly, a potential EU-wide oil embargo could significantly undermine the already diminishing availability of Russian barrels; it may be as much as 3 mbpd, the IEA estimates. The country’s economy ministry released its production and exports forecasts last week; it is a grim reading. Oil output is set to fall 9% year-on-year under the “baseline” scenario and 17% in the conservative scenario. The estimates for crude oil and product exports are -1%/-8% and -20%/-41% respectively.

It is the latter, product exports that are frightening and already have a tangible impact on oil prices. The latest rally has been led by products, particularly by the ones in the middle of the barrel. ICE Gasoil gained 22% in April with the Gasoil/Brent crack spread jumping from $34/bbl to $55/bbl. CME Heating Oil made a new record high last Thursday (and again rallied hard yesterday), the 3-2-1 crack spread jumped from $122/bbl at the end of March to nearly as high as $200/bbl last Thursday. The Heat/WTI price differential more than doubled in April and settled at $110/bbl on Thursday although expiry-related profit-taking pushed its value down to $96/bbl a day later. Russia’s export of ultra-low sulphur diesel is to sink by around 30% from the Baltic port of Primorsk in May. US distillate stocks are fast approaching 100 million bbls (diesel inventories have already dipped below this mark) with exports at a healthy 1.2-1.4 mbpd as European appetite for distillate/diesel proves insatiable. In fact, because of rising US export volumes allocations on the Colonial Pipeline, the US’s most important product artery that ships refined oil from the USGC to the East Coast demand centre are dropping speedily. The situation is dire, and the end is not in sight. No doubt, demand will react to higher prices in due course and the seeds of a massive price fall are being sown by resilient oil prices supported by the war in Ukraine. The harvest season, however, will unlikely arrive until after the summer.