Beneath the surface: what’s really going on with the price of oil?

It’s a tough time to be an oil trader.

The market feels like it should be bullish: global supply is being squeezed, and services demand is still strong. The world’s inventories are low, a notable slowdown of activity in the US, and then the Saudis and OPEC+ reiterated their intention to limit supply last week.

And yet the market has reacted with little more than a shrug, with the price of crude oil staying comfortably beneath that $80 per barrel figure where it’s been stuck for most of the year.

Energy has struggled as one of the weakest performing asset classes this year

Despite oil outperforming natural gas, it has significantly lagged behind other commodities and macro assets, even as the fundamentals have tightened.

So, what’s the real story?

On the surface, it’s pretty clear what’s weighing on the price of oil.

The global economic picture is worsening: the Eurozone is now in recession, and the boost from China’s reopening has underwhelmed.

The uncertainty around Russia’s supply cuts has also muddied the waters. The simple fact is that no one really knows how much physical oil is in the market. It’s difficult for investors to trust the data around oil supply and demand when there seems to be little change in crude shipments from Russia’s ports despite saying it was fulfilling its pledge to cut supply.

All of this has dampened market sentiment, and speculative positions have reached record short levels. But drill beneath the surface, analysing the data in depth, and a different picture emerges. One that is more complex but also more positive for the price of oil in the medium term.

Picture of an oil rig in the sea at dawn

The Saudi Lollipop

“This is a Saudi lollipop. We wanted to ice the cake. We always want to add suspense. We don’t want people to try to predict what we do. This market needs stabilisation.”

Prince Abdulaziz bin Salman, Energy Minister, Saudi Arabia

Vivid language from the Saudi Energy Minister at the Opec+ meeting on June 4, as he said the country’s output would drop to 9 million barrels per day (bpd) in July from around 10 million bpd in May, the biggest reduction in years.

Lollipop or not, the announcement didn’t give the market the boost the OPEC+ countries would have hoped. In truth, an output cut was priced in but probably served to only prevent a slide after a set of mixed economic figures out of China in recent weeks.

The reality is that the bearish speculators irked Prince Abdulaziz in recent weeks; he told them to “watch out” towards the end of May, but they are still in control for now.

However, that market pessimism could easily be upended by the tighter picture we expect in the second half of the year, when demand could outstrip supply by as much as 2 million bpd, according to the International Energy Agency.

The Supply Story

Can the market trust the global oil supply data being reported?

That’s a key question that’s currently weighing heavily on market sentiment. The discrepancies we’re seeing between the published estimates of oil flows and the actual physical market activity appear to be significant, and although OPEC+ last week announced their extension of supply cuts into 2024, the reality is that some members, including Angola, Nigeria and Congo, aren’t meeting their current supply quotas. On that basis, these “cuts” merely bring their targets closer to their actual production capacity.

The oil supply uncertainty is only exacerbated by the ‘shadow fleet’ of oil tankers helping Iran and Russia evade sanctions. According to the IEA, Russian oil exports in March hit their highest levels since April 2020, despite the EU implementing a seaborne import ban and a price cap policy instigated by the G7 of $60/barrel.

An overhead image of docked tankers refuelling at night

There’s also significant doubt about Russia’s commitment to its own voluntary supply cut of 500k bpd, with the IEA suggesting in May that the country “may be boosting volumes to make up for lost revenue.” 

But the disconnected supply picture isn’t just an OPEC+ challenge.

In the US, the Energy Information Administration (EIA) has also struggled with its own accuracy issues, making significant adjustments to the U.S. supply statistics in recent months.

What’s certainly true is that there’s been a notable slowdown in activity in the U.S. This can be seen in the declining number of oil rigs, and frac spreads compared to the previous year. Additionally, the number of drilled but uncompleted wells in the Permian Basin, in Texas and New Mexico, has decreased significantly, preventing a surprise outperformance in US production.

It may take a little longer for the supply squeeze narrative to fully convince investors, but we believe it’ll be one of the biggest factors in upward pressure on prices in the second half of the year.

This is due to a lack of global inventories despite coordinated releases from government strategic reserves last year. And these inventories are expected to continue drawing down in the second half of the year. They could reach critically low levels by the fourth quarter.

If – as we believe – inventory draws accelerate over the summer, and Saudi cuts exacerbate the issue, then any disruption on the supply side could be the catalyst that the bulls need to see more positive price action.

Where’s the demand?

We believe the oil market is being unduly pessimistic about the world’s demand for oil for the rest of 2023.

While markets are focused on disappointing manufacturing data, we note that services, which drive 70% of global oil demand, have remained robust and above expectations.

This has led the IEA to consistently revise its 2023 demand forecast higher since the end of last year. Strong refinery margins also indicate resilient end-user demand for gasoline, jet fuel, and diesel, suggesting that the demand for crude oil will stay resilient.

China’s reopening rebound may have slowed sooner than expected: recent data showed lower exports and industrial output than expected, and retail sales narrowly missed forecasts in May, but regardless, China’s demand for oil shows little sign of weakening.

The International Energy Agency (IEA) said in May’s ‘Oil Market Report’ that it expects global oil demand to increase faster than expected this year to reach 102 million-bpd.

According to the agency, global oil demand – supported by rising Chinese demand – will increase by 2.2 million-bpd year on year in 2023, some 200,000 bpd higher than its previous forecast.

An oil field at sunset

The IEA cited a notable recovery in China’s mobility data in March as the momentum behind a 450,000-bpd month-on-month rise in demand in the country to a new record of 16 million bpd. It added that China’s annual demand is set to average 16 million bpd for the whole of this year, up by 1.3 million bpd from 2022.

Whether those numbers are supported by the fragile Chinese economic recovery for the rest of the year is yet to be seen, but India also showed real strength in oil demand in May, underpinned by record diesel consumption and the best manufacturing numbers for the country since the beginning of Covid.

Undoubtedly, there are still cross-currents ahead in oil markets before we see prices start to rise.

The prevailing view of the world economy is far from positive; China and India are masking stagnant growth in most OECD countries, and the Eurozone is now officially in recession. But the underlying data points to a more positive outlook, despite the pessimistic mood.

Low global oil inventories, resilient services driving demand, a slowdown in US production growth, and the Saudi “lollipop” will all eventually prove irresistible for investors.

It may currently be a tough time to be an oil trader, but we expect the fundamentals to win out and prices to move higher in the second half of the year.