Rising Tensions in the Middle East Propel Oil Prices to a Three-Month High
March ’24 WTI gained $2.35, or 3%, this week to finish at $79.19/Bbl. Oil prices have extended gains from last week to finish at their highest level since November as rising geopolitical tensions in the Middle East countered the weaker IEA demand outlook.
Front-month WTI found support on Friday following reports that Hezbollah chief Hassan Nasrallah said the group will escalate its fight with Israel, heightening risks in the region.
Additionally, Israeli Prime Minister Netanyahu has opted not to participate in the ceasefire talks with Hamas this week amid worsening tensions with Hezbollah and a firm stance against withdrawing troops from Gaza. Meanwhile, Houthi attacks on Red Sea shipping continue, compelling many merchant vessels to avoid the waterway.
Shifting to fundamentals, the IEA, in its monthly oil report, indicated that the oil market could be in a near 1 MMBbl/d surplus for the rest of 2024, citing global oil demand growing by just 1.2 MMBbl/d in 2024—about half of 2023's growth rate. In contrast, OPEC expects a deficit in global oil markets, with strong demand growth projected at 2.25 MMBbl/d in 2024.
AEGIS is modestly bullish on the curve and expects global inventories to remain at a deficit to the five-year average as OPEC+ started enforcing its additional supply curbs.
Furthermore, OPEC+ is set to meet in early March to decide whether to extend oil output cuts into 2Q 2024, with Saudi Arabia’s energy minister saying they “absolutely” could be prolonged. The cartel pledged close to 0.9 MMBbl/d of production cuts in 1Q ‘24 in addition to Saudi Arabia’s voluntary 1 MMBbl/d cut and Russia’s 0.5 MMBbl/d export curbs.
Crude Oil Factors
Geopolitical Risk Premium. (Bullish, Surprise) 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 since October 7. 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. Yet, with no Middle East production disruptions observed, the initial war premium is currently getting no credit in the price action.
Cease-fire prospects in the Israel-Hamas conflict dimmed as Israel geared up for operations in southern Gaza amidst escalating tensions in the oil-rich region. Netanyahu's insistence on "total victory" over a ceasefire, combined with Iraq's threat to withdraw support from the U.S.-led coalition, further complicated matters. Concurrently, intensified Houthi attacks on merchant vessels this week have led major shipping firms to caution that the security situation in the Red Sea is worsening.
Simultaneously, the frequency of Houthi assaults on commercial vessels has surged over the week, prompting leading shipping companies to alert that the security conditions in the Red Sea are further declining.
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, 2023. 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.
Trade Flows. (Bearish, Priced In) Traders stepping back from speculative positions on potential conflict-driven rallies has increased volatility and is exerting upward pressure on oil prices. 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 rally in the crude market is attributed to algorithmic buying.
According to data from Bridgeton Research Group, trend-following algorithms have been exacerbating oil's moves. Trend followers, after a significant market shift on Thursday, have moved from being net short to holding net long positions in Brent (45%) and WTI (30%) for the week ending Jan 26. This week, prices fell by $2 on Thursday following a tweet from Al Jazeera saying Israel and Hamas agreed to a ceasefire proposal. Bloomberg reported that oil prices fell below their 200-day and 50-day moving averages, which triggered trend-following algorithms, exacerbating the decline.
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.
Since the beginning of 2024, Russian oil refineries have been significantly affected by Ukrainian drone attacks. The attacks have led to a reduction in Russian oil refinery output by 4% in January 2024 compared to the same period the previous year, as reported by Russian state-controlled media. These incidents have been part of a series of strikes targeting Russian energy infrastructure, including attacks on oil depots and refineries in various regions, contributing to disruptions in Russia's ability to export oil products. Additionally, Russia has adhered to its pledge and curbed exports by 0.49 MMBbl/d in January.
OPEC Market Share War. (Bearish, Surprise) The possibility exists, albeit a small one, that should OPEC's efforts to bolster oil prices through production cuts prove unsuccessful, the cartel could potentially flood the market with additional barrels as a strategy to reset.
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 106 MMBbl below the five-year average in October. 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 have caused concern for demand throughout 2023. The 10-year Treasury hit 4.8 in October, 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 rise by 2.4% 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. Some analysts expect the Federal Reserve to cut interest rates in 2H 2024. Lower interest rates cut consumer borrowing costs, which can boost economic growth and oil demand.
OPEC+ Quotas. (Bullish, Priced In) OPEC+ agreed to cut an extra 0.88 MMBbl/d in the first quarter of 2024, adding to Saudi Arabia's existing 1 MMBbl/d reduction. This aims to reduce the forecasted supply surplus of 1.3 MMBbl/d next quarter (IEA). However, skepticism among market participants due to the voluntary nature of the cut and Angola's non-compliance led to a decline in oil prices following the announcement. The UAE, Kuwait, Iraq, Kazakhstan, and Algeria, announced their respective production cuts following the meeting.
China Demand. (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. As 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 Federal Reserve kept rates unchanged on Jan 31, and Chairman Powell said that interest rate cuts in March are “probably not the most likely case”. Fed's signal of not starting to cut rates led to a stronger U.S. dollar last week. This, in turn, makes oil, priced in USD, more expensive for holders of other currencies, potentially weighing on demand. However, some analysts are penciling in three rate cuts in 2024, which could stimulate economic growth and may further support the demand outlook.
Non-OPEC Production. (Bearish, Priced-In) 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. OPEC forecasts the 2024 non-OPEC production to increase by 1.4 MMBbl/d.
EIA, in its monthly STEO report, reduced its 2024 U.S. oil (liquids) production growth forecast to 0.16 MMBbl/d from an earlier 0.27 MMBbl/d. If accurate, EIA’s modest U.S. oil production growth forecast, which counters IEA’s forecast of nearly 0.7 MMBbl/d growth, could support prices.
SPR. (Bullish, Surprise) The U.S. DOE has bought back nearly 23 MMBbl of crude so far. DOE also solicited 3 MMBbl for June 2024. 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.
OPEC Reversal/Compliance. (Bearish, Surprise) The new voluntary OPEC+ production cuts put member nations' adherence to quotas under scrutiny. Any deviation, such as halting, reversing, or exceeding their quotas, could end up being one of the surprise bearish factors weighing on the market.
China Inventories. (Bearish, Mostly Surprise) China has an inventory capacity of 1 -1.2 Billion barrels, and inventories are currently around 900 MMBbl as of January, according to Vortexa. Over the first eight months of 2023, China accumulated about 130 MMBbl in its oil inventories, giving it considerable flexibility in its import decisions. Since August, China has been destocking, withdrawing approximately 100 million barrels. If prices remain range-bound or relatively low, China might start restocking, preparing for times when refiners, responding to high global prices, opt to reduce imports and draw more from these stockpiles. This could exert downward pressure on global crude prices. Historically, China has reduced imports when crude prices surge; however, the market seems 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.
Furthermore, 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 3.4 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. The possibility of ending or reducing Iran sanctions poses a downside risk to oil prices.
China-Taiwan Conflict. (Bearish, Surprise) Should the China-Taiwan conflict escalate, it may lead to increased sanctions on China, the world's largest oil consumer, and pose a significant bearish risk to oil prices. These sanctions could substantially weigh on China's oil demand. Beyond the oil market, such sanctions would have broader repercussions, disrupting international trade, undermining global economic stability, and straining geopolitical relations. The impacts would be felt across global supply chains and in countries reliant on economic ties with China.
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