La Française: Are we at the end of an oil super cycle?

July 21, 2022

by Audrey Bismuth, Global Macro Researcher, La Française AM

On two occasions in July, the WTI (West Texas Intermediate) dipped below $100 a barrel for the first time since April as fears of deep recession grow, the dollar strengthens and the number of covid cases rises in China, the world’s second largest oil consumer.

In its July monthly report, the US Energy Information Administration emphasized 2022 would be the first year since 1999 that growth in oil consumption in OECD countries outpaces growth in non-OECD countries. Around the world, central banks will have to hike rates aggressively to fight against persistent, broader and highly elevated inflation. They must “cool” demand until inflationary pressures ease. Consequently, oil traders have cut their net long positions since June.

 
However, fundamentals remain strong: OPEC+ supply shortfalls, low inventories, dwindling spare capacity, elevated refining margins driven by seasonal demand and disruption in Russian exports. The forward futures stay heavily in backwardation (futures price is lower than spot price) which is theoretically bullish for the spot price. On July 18, the brent spot price recovered at around $106 and brent crude futures for December 2022 settled slightly lower at $96 a barrel. Prices for physical Brent crude have soared to their highest since 2008 according to Bloomberg.

 
The global oil demand is still growing. Analysts at the International Energy Agency and at the US Energy Information Administration expect global oil demand to increase by at least 2 million barrels a day (b/d) in 2023, to 101,3 million b/d and 101,6 million b/d respectively, bringing it back above the 2019 level. OPEC is more optimistic and expects an increase in global oil demand of 2.7 million b/d. Global oil demand growth will be led by a strong growth trajectory in non-OECD countries namely Asia, where growth is driven by a rebound in the demand for kerosene. Obviously, the decelerating economic activity could lead to some downside revision in the future. However, historically, oil demand has only contracted in the worst of global recessions. According to J.P.Morgan, with the exception of the COVID-driven recession of 2020, annual oil demand has never contracted by more than 3.0 million b/d in a year. Among all the years when oil demand fell year over year, 60% of the time the drop in demand was limited to under 1.0 million b/d, and 20% of the time demand fell by 1.5-2.0 million b/d.

 
On the supply side, analysts anticipate range-bound production from OPEC countries and larger supplies from non-OPEC producers, fueled by the United States. OPEC+ countries continue to deliver lower supply increases than the monthly production quotas despite oil prices which have steadied at around $105 since the beginning of the year. The 10 producers in the OPEC+ agreement produced 24.8 million b/d, which was 1 million b/d below OPEC’s target for June. The inability to boost production is likely to continue given aging infrastructure and years of low investments. Only Saudi Arabia and the United Arab Emirates have enough spare capacity to pump more. According to the International Energy Agency, their combined buffer could fall to just 2.2 million b/d in August with the full phase out of record OPEC+ cuts. Saudi Arabia currently produces around 11 million b/d and reported maximum sustainable capacity of 12 million b/d. It has achieved 11.5 million b/d one time in April 2020. In addition, despite talks, the United States and Iran failed to restore the Iran nuclear deal. In the United States, output remains at about 1.0 million b/d below the pre-pandemic high. Investor pressure to maintain capital discipline is the primary reason why publicly traded oil producers are restraining growth despite high oil prices. The world’s five largest oil companies plan to invest $81.7 billion this year, half of what they spent in 2013. Inflation, supply chain issues, labor shortages and less operator activity have also limited production growth. After 11.6 million b/d in the first semester of 2022, the US Energy Information Administration expects U.S. crude oil production will rise to an average of 12.2 million b/d in the current semester and to 12.8 million b/d in 2023, which would surpass the previous annual record set in 2019. The increased production of associated natural gas from the Permian basin, the largest petroleum-producing basin in the United States, also poses a downside risk to its crude oil production over the next months.

 
Global oil inventories remain extremely low. OECD industry stocks have recovered somewhat thanks to sizeable government stock releases (which are schedule to end in October) but remain nearly 300 million barrels below their five-year average. Furthermore, tightening supply will be challenging as the European Union’s embargo on Russian oil is set to come into full force at the end of the year. According to the International Energy Agency, Russian oil exports in June fell by 250 000 b/d to 7.4 million b/d, the lowest since August 2021.

 
Overall, volatility in crude oil prices is likely to continue until inflation pressure eases, but the dynamic remains supportive of oil prices, i.e., futures curves remain in “backwardation”.