Middle East Tensions Stoke Supply Fears in an Already Tight Market
The ongoing conflict between Israel and Hamas is exacerbating geopolitical concerns in the oil market. Nov ’23 WTI, as it expired, gained $1.06/Bbl, or 1.13% this week, finishing at $88.75/Bbl. Furthermore, Putin said last week that despite the Israel-Hamas conflict pushing oil above $100/Bbl, Saudi and Russian supply cuts will persist.
AEGIS maintains a bullish stance on oil prices. Currently, OECD inventories are 106 MMBbl below the five-year average, with projections indicating further drawdowns. The supply cuts by OPEC+ should keep this market tight and reduce inventories.
Meanwhile, on the frontlines of conflict, the US is seeing more drone attacks in Iraq and Syria, while an American destroyer intercepted missiles and drones fired toward Israel by Houthi rebels in Yemen. On Thursday, Israel attacked Hamas in Gaza and Hezbollah in Lebanon, with a potential ground invasion of Gaza on the horizon. The escalation raises concerns of a broader conflict, potentially drawing in Iran and increasing the US military presence in the area.
There’s a risk the U.S. takes a tougher stance on sanctions enforcement, reversing a looser approach that has allowed Iran to increase output by more than 0.5 MMBbl/d this year. Consequently, any disruptions in the Strait of Hormuz or attacks on vessels, export terminals, or infrastructure could amplify the risk to supply.
However, oil prices found some temporary resistance as the US announced easing sanctions on Venezuela for a six-month period. As of September, Venezuela is producing 0.8 MMBbl/d, up from 2022's average of 0.67 MMBbl/d but below the 2.4 MMBbl/d seen before the 2017 sanctions. With relief, analysts estimate a 0.2 MMBbl/d increase in output over an 18-month period.
Considering constrained OPEC+ supply, low inventories, tightening physical market, resilient demand, and geopolitical risk, AEGIS recommends hedging WTI using swaps, given the rally in the WTI curve in recent months.
Crude Oil Factors
Geopolitical Risk Premium. (Bullish, Mostly Priced In) Considering the turmoil hitting several countries in the eastern hemisphere, we decided to add this factor. Most headlines were dominated by the escalated conflict between Hamas and Israel over the weekend. The risk premium in the oil markets is most likely because of the potential supply risk from Iran. The knowledge that the Iranian government has backed Hamas and reports that Iran helped plan the weekend's attack leads many to believe there could be action taken against Iran. A harder line from Washington on Iran’s oil supply or retaliation from Israel directly on Iran are possibilities.
Furthermore, last year's Russian invasion of Ukraine continues to weigh on prices. The EU and G7 approved the eighth set of sanctions and a price cap on Russian oil imports, which came into effect on December 5. The EU and G7 agreed upon a $60/Bbl price cap on Russian crude, which will be reviewed bi-monthly. The EU implemented a similar price cap mechanism on Russia's fuel exports on February 5. Escalating tensions in the eastern hemisphere, including the alliance of Saudi Arabia and Iran mediated by China, along with reports of potential Saudi-Syria ties, which could further impact the region's stability, might also act as a risk premium on oil prices.
Trade Flows. (Bullish, Priced In) Oil prices tracked equity markets since March as renewed worries over the U.S. and European banking sectors subsided. AEGIS also notes that the recent movement in prices could be driven by the price trend (technical selling or buying) itself rather than the fundamentals. We see that trade flows have been affecting the price action in the commodity markets for the past few weeks, as the recent selloff in the crude market is attributed to major funds/firms liquidating. Up until last Tuesday, WTI had rallied 27% since early July. Speculators have piled into bullish bets in crude oil over the past three months and, at the same time, reduced outright short positions. Therefore, it’s not too surprising that a myriad of bearish items that hit the market this week caused the spec community to take profits or reduce length (no evidence of this yet until CFTC data is released next week).
Iran. (Bearish, Surprise) The Iran nuclear deal negotiations concluded on August 8 after 16 months. U.S. Secretary of State Antony Blinken said that an agreement in the near future is unlikely. However, Iran's production and exports have surged to over 3 MMBbl/d and nearly 1.5 MMBbl/d, respectively, due to quiet diplomacy with the U.S. after Iran released five Americans in September. If an agreement is reached, the nation may increase output by nearly 1 MMBbl/d, perhaps starting in phases beginning in 2023. The possibility of ending or reducing Iran sanctions poses a downside risk to oil prices. This is one of the bearish non-economic factors that could pressure oil prices in 2023.
U.S. - China Tensions. (Bearish, Surprise) The tensions between the U.S. and China have been fueled by a range of issues, including trade imbalances, technology competition, human rights concerns, military tensions, and ideological differences. Both countries have accused each other of unfair practices while expressing concern about the other's actions. The latest trade tensions stem from the U.S.’s effort to clamp down on China’s access to critical semiconductor technology and to impose export restrictions.
According to a Goldman Sachs survey at their Global Macro Conference (January 2023), ‘U.S. – China tensions’ were the most concerning factor to many investors this year. Escalated tensions between the U.S. and China could potentially reduce demand due to trade barriers and slower economic growth.
Russian Supply. (Bullish, Priced In) Russia, the largest seaborne diesel-type fuel exporter, has halted diesel and gasoline exports from September 21 with no clear end date to control rising domestic fuel prices. Russia also extended its export curbs through December, though it tapered the curbs from 0.5 MMBbl/d in August to 0.3 MMBbl/d. Moscow has previously pledged to cut production by 0.5 MMBbl/d from March through 2024. Russia's total petroleum exports are estimated to be around 7 MMBbl/d, and the absence of even a portion of this supply, given that Russia is the world's third-largest supplier of oil, would be a significant influence in driving up prices. China and India remain to be the biggest buyers of Russian crude. The sanctions and price cap are estimated to risk 0.5 to 1.5 MMBbl/d of Russian oil production. The U.S. sanctions on two tankers for exceeding the Russian oil price cap intensify supply concerns in a market anticipating global inventory reductions through 4Q2023.
Oil/Product Inventories. (Bullish, Priced In) Crude and refined product inventories in both the U.S. and abroad are extremely low. The EIA released its weekly oil inventory report Wednesday morning, showing a big drop in gasoline demand. In fact, it marks the lowest level in 25 years on a seasonal basis. Cushing stocks rose modestly, but this was more or less expected as refiners turned to maintenance and reduced runs. Crude data is usually on a several-month lag. IEA data shows that OECD inventories were nearly 115 MMBbl below the five-year average in June. The oil market has likely remained in a slight supply deficit since then, so inventories could be lower now, as evidenced by the backwardation in the forward curve. Additionally, volatility will likely be heightened with inventory levels at inadequate levels to serve as a "shock absorber" for prices. Distillate fuel inventories in the U.S. are 13% below the five-year average for this time of year. Meanwhile, exports continue to be high as refiners attempt to address global shortages brought on by the pandemic's quick recovery and the disruptions caused by Russia's invasion of Ukraine.
Economic Slowdown. (Bearish, Mostly Priced In) Higher interest rates are causing concern for future demand. The 10-year Treasury hit 4.8 on Wednesday, the highest level since 2007. Threats to global GDP impact oil demand growth projections. Higher global energy prices might increase the potential for an economic slowdown. Macroeconomic uncertainties could pressure oil demand and, therefore, oil prices in 2023. According to the EIA, U.S. real GDP declined by 2.8% in 2020, and they estimate U.S. GDP increased by 5.9% in 2021. They estimate GDP has risen by 2.1% in 2022 and are forecasting it would fall by 1.9% in 2023. While that doesn't sound all too bad, the main takeaway is that crude oil demand growth would likely slow with GDP, and if supply growth outpaces demand growth, then you would find yourself in a structurally weaker market. U.S. inflation was steady in September, with annual CPI at 3.7%. However, Fed officials are expected to hold rates steady while debating if another rate hike in November or December will be necessary to maintain recent progress in slowing inflation.
OPEC+ Quotas. (Bullish, Priced In) OPEC+ extended their voluntary cuts of 1.66 MMBbl/d from May to the end of 2024, aiming to stabilize the oil market. Saudi Arabia and Russia will take the lead with reductions of 0.5 MMBbl/d each, followed by other member nations. In addition to that, Saudi announced a 1 MMBbl/d production cut for July through September with an option to extend it. Concurrently, Russia announced that it will cut its exports by 0.5 MMBbl/d for August and 0.3 MMBbl/d for September. On September 5, Saudi and Russia announced an extension of their existing 1 MMBbl/d and 0.3 MMbbl/d (exports) voluntary cuts through December.
Furthermore, Putin announced on Oct 18 that the cuts to oil supplies imposed by Saudi Arabia and Russia would “most likely” continue despite market concerns that the conflict between Israel and Hamas could drive crude prices to $100 a barrel.
Many OPEC+ members, including Russia, are already vastly underproducing compared to their quotas. This policy of quotas, which had been in place since mid-2021, has been revised in light of a decline in Russian output due to additional sanctions. Many analysts question how much spare capacity the group really has left. Several countries, such as Angola and Nigeria, have oversupplied relative to their quotas.
China Growth. (Bullish, Partly Priced In) China's oil demand has been severely affected in 2022 by strict COVID-19 control measures. Reduced mobility has hindered economic activity and, therefore, consumption. China eased its Covid restrictions in early December 2022 and announced a slew of economic measures to boost its economy. When the country completely emerges from the lockdowns, its oil demand is expected to rise, putting extra strain on a market that has already tightened dramatically since Russia invaded Ukraine. Chinese oil consumption is expected to hit a record high this year. According to the IEA, Chinese demand is expected to increase by 1.3 MMBbl/d in 2023. China’s demand is important as it is nearly half of the global demand growth in 2023, which the market expects to grow by about 2.4 MMBbl/d. China's Central Bank lowered the reserve requirement ratio (RRR) by 25 bps in an effort to stimulate the nation's economy.
USD/Fed (Bearish, Priced In)The Fed's rhetoric around higher rates for longer has spooked the equity markets and has caused concerns for future economic growth. At the same time, the US dollar reached a new 11-month high of 107 last week before easing to 106 this week. A higher dollar can make oil more expensive for foreign buyers of crude oil that is priced in dollars.
Non-OPEC Production. (Bearish, Surprise) Many prominent research groups (EIA, IEA, OPEC) think non-OPEC production, dominated by the U.S., will increase in 2023. If these forecasts come to fruition, it would have a slightly bearish impact on oil prices if the market were otherwise well-supplied. IEA forecasts the 2023 non-OPEC production to increase by 0.8 MMBbl/d.
SPR. (Bullish, Surprise) The U.S. DOE announced plans to buy 6 MMBbl of sour crude for the strategic petroleum reserve delivery in December and January at $79 or less. In response to the Russia-Ukraine war and rising gasoline prices, the Biden administration drew the SPR by 180 MMBbl to a 40-year low of 351 MMBbl from its 714 MMBbl capacity. Additionally, the DOE confirmed a prior purchase of 4.8 MMBbl at an average price under $73/Bbl and said it will continue monthly solicitations for available capacity through May 2024.
OPEC Reversal. (Bearish, Surprise) OPEC halting or reversing their pre-emptive/proactive production cuts could be one of the surprise bearish factors weighing on the market.
China Inventories. (Bearish, Surprise) China has an inventory capacity of 1 -1.2 Billion barrels, and inventories are currently around 860 MMBbl as of July, according to Kpler. Over the first eight months of the year, China accumulated about 197 MMBbl in its oil inventories, giving it considerable flexibility in its import decisions. If China's refiners, influenced by high global prices, opt to reduce imports and tap into these stockpiles, it could exert downward pressure on global crude prices. Historically, China has reduced imports when crude prices surge. Yet, the market appears to be underestimating this potential impact on crude demand.
"Fragile Five" Production. (Bearish, Surprise) The Citi bank coined the term that includes Iran, Iraq, Libya, Venezuela, and Nigeria - which have historically faced turbulence in their crude oil production. However, despite past disruptions, they are projected to boost production by approximately 0.9 MMBbl/d barrels this year, and a similar increase is expected next year. This surprising growth in output could pose a bearish risk to global crude prices, especially as oil demand may be tempered by slowing expansion in China.
Government Intervention. (Bearish, Surprise) There's potential downside risk if the Biden administration intervenes to address high gasoline prices by releasing more crude from the SPR, especially considering it's an election year. The US announced easing sanctions on Venezuela for a six-month period. As of September, Venezuela is producing 0.8 MMBbl/d, up from 2022's average of 0.67 MMBbl/d but below the 2.4 MMBbl/d seen before the 2017 sanctions. With relief, analysts estimate a 0.2 MMBbl/d increase in output.
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