Oil Falls on Prospect of Higher Supply
WTI prices slid again this week amid a Saudi scare and potentially recovering Libyan production. The November contract finished Friday at $68.18, down from $71 the previous Friday.
Last week, we painted a shift in our 2025/26 sentiment. The forecasted data and OPEC+’s future strategies suggest that the oil market is likely to be oversupplied in 2025, leading to a more bearish scenario. Therefore, we are shifting our outlook for 2025 and 2026 to neutral from bullish. We still maintain our neutral view on the rest of 2024 as OPEC+ is still holding their voluntary cuts for now and a good amount of crude pessamissm has been captured in the price below $70. Evidence of this pessimistic shift can be found in speculator positioning that put both WTI and Brent near or at the one percentile in net length.
Here are a few points that lead us to our 2025 view shift:
In summary, oil inventories are likely to rise. Historically, oil prices typically trade where inventories sit compared to the surplus or deficit to the five-year average. OPEC+ has kept OECD inventories at a fairly consistent deficit to the five-year average. If 2025 is oversupplied, stocks would rise, imputing a lower price.
Turning to hedging. While we think the rest of 2024 could materialize near current front-month prices, we would suggest swap structures in 2025 to provide the most protection. Some producers may want to employ costless collars if they hold an alternative view, but put-skew can make these structures more unattractive than swapping.
Crude Oil Factors
Geopolitical Risk Premium. (Bullish, Surprise) As there has been no disruption to any supplies so far, prices have shaken off the attacks on ships in the Red Sea and also the ongoing Israel-Hamas conflict. However, headline risks have the potential to shock prices higher in the near term. Considering the turmoil hitting several countries in the eastern hemisphere, we decided to add this factor. Since October 7, 2023, most headlines have been dominated by the escalated conflict between Hamas and Israel. The knowledge that the Iranian government has backed Hamas leads many to believe action could be taken against Iran.
Additionally, Libya’s eastern government announced plans to shut down all oil production and exports amid an escalating conflict with the Tripoli-based government over central bank control and oil revenue. Libya’s NOC announced last Friday that about 63% (0.75 MMBbl/d) of the 1.2 MMBbl/d of Libya's production is halted.
Some geopolitical risk premium is priced back into oil prices following Ukrainian drone attacks on Russian refineries; this happened numerous times this year. The June 20 attacks knocked out nearly 5% of Russia's refining capacity, according to Bloomberg estimates.
Iran announced retaliatory strikes against Israel in response to airstrikes in Iran and Lebanon that killed a Hamas leader on July 31. The conflict has escalated following a Hezbollah attack on Israel, which now threatens to undermine the ongoing cease-fire negotiations. However, progress in ceasefire talks between Israel and Hamas, involving U.S. and Israeli delegations in Cairo, have helped ease concerns about potential disruptions to oil supplies.
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. (Mostly Bullish, Priced In) Traders stepping back out of speculative positions on amid potential weakness in demand and broader equities sell-off is exerting downward pressure on oil prices. Oil prices tracked equity markets since March 2023 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 price action in commodity markets in recent months, as recent movements in the crude market have partially been attributed to algorithmic selling.
Money managers have reduced net bullish WTI bets to the lowest in seventeen weeks. This reflects increased bearish sentiment due to OPEC⁺'s plan to unwind production cuts and a weak global economic outlook. Manufacturing momentum has stalled, and concerns about economic deceleration have pushed oil prices to their lowest level this year. However, if the slowdown doesn't materialize and inventory depletion continues, prices could rebound, driven by fund managers rebuilding positions.
Russian Supply. (Bullish, Priced In) 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, Ukrainian drone attacks have significantly affected Russian oil refineries. The attacks reduced Russian oil refinery output by 14% in May. These incidents are 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. Furthermore, Ukraine conducted a swarm of drone attacks on four Russian refineries on June 20.
Russia's crude oil revenues hit a seven-month low as global prices tumbled, with Urals crude nearing the G7's $60/Bbl price cap. Average crude export volumes slipped by 30 MBbl/d to 3.13MMBbl/d, while Moscow faces additional production cuts in October and November to offset earlier overproduction. Exports to Asia, particularly to China and India, remain robust despite a 10% drop from April levels. Total export income fell to $1.44 billion, the lowest since January, driven by declining global prices.
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, Mostly Priced In) Crude inventories in the US sit at the lowest level since January while stocks at Cushing are at their lowest since November. Meanwhile, refined product inventories in both the U.S. and abroad are low. Crude data is usually on a several-month lag. According to the August IEA report, OECD inventories were nearly 70 MMBbl below the five-year average as of 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. Distillate fuel inventories in the U.S. are 9% 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) The latest U.S. economic data revealed a stronger-than-expected GDP growth of 2.9% annualized in 2Q. Meanwhile, the PCE price index, the Fed's preferred inflation measure, rose 2.5% Y-o-Y in July, aligning with market expectations and bolstering speculation of a September rate cut. In August, the CPI rose by 2.5% Y-o-Y, indicating that inflation is falling in line with the Fed’s 2% target. Major banks, including JP Morgan, Citi, and Wells Fargo, now forecast at least a 25 bp rate cut in September. Macroeconomic uncertainties could pressure oil demand. 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. 2.5% in 2023 and are forecasting it would rise by 2.4% in 2024. 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.
OPEC+ Quotas. (Bullish, Priced In) On June 2, OPEC+ announced its extension of 3.66 MMBbl/d cuts through December 2025. Additionally, the 2.2 MMBbl/d voluntary cuts from eight member countries will continue into Q3 2024 but will start to be reversed in October at a rate of 0.18 MMBbl/d per month. OPEC+ members agreed on September 5 to delay a planned gradual 2.2 MMBbl/d supply hike by two months, shifting the start to December. The group will add 0.19 MMBbl/d in December and 0.21 MMBbl/d from January onwards, with an option to adjust or pause these hikes depending on market conditions. The cartel also reaffirmed its compensation cuts of 0.2 MMBbl/d per month through November 2025, as members such as Iraq, Russia, and Kazakhstan have struggled to meet their original production quotas.
AEGIS notes that the global crude market would quickly build inventories without OPEC's support in reducing supply. Furthermore, IEA now projects a deficit of 0.1 MMBbl/d, starkly contrasting with its previous forecast of a 0.8 MMBbl/d oversupply and consequent inventory builds. This adjustment stems from the first-time inclusion of expected OPEC+ production cuts extending through the year's end, a view that diverges from OPEC's own announcement of cuts lasting until 2Q 2024.
China Demand. (Bearish, Mostly 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 emerged from the lockdowns, its oil demand was expected to rise, putting extra strain on a market that has already tightened dramatically since Russia invaded Ukraine. However, the pace of Chinese demand growth has been slow compared to what the market had expected. Chinese oil consumption is expected to hit a record high this year. According to the IEA, Chinese demand rose by 1.7 MMBbl/d in 2023 and is expected to increase by just 0.18 MMBbl/d in 2024. China’s demand is important as it is nearly half of the global demand growth in 2024. However, China's apparent oil demand fell 8.02% Y-o-Y in July to 13.55 MMBbl/d, driven by weakness in fuel demand.
USD/Fed (Bullish, Surprise) Traders have increased their bets on a half-point interest rate cut by the Federal Reserve, pushing down bond yields and weakening the dollar. This shift comes after a Wall Street Journal report suggested that Fed policymakers are weighing a more aggressive cut. The dollar declined against most major currencies as the likelihood of a larger rate cut increased, signaling market uncertainty ahead of the Fed's upcoming meeting.
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. IEA forecasts the 2024 and 2025 non-OPEC production to increase by 1.5 MMBbl/d.
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.
Ceasefire(s). (Bearish, Surprise) The crude oil market is currently seeing price action partly due to the geopolitical risk premiums associated with three major conflicts: the Russia-Ukraine war, the ongoing Israel-Hamas hostilities, and the Houthi attacks on Red Sea shipping. These conflicts have significantly contributed to the uncertainty in the oil markets, pushing prices upward/downward as market participants weigh the risks of supply disruptions and increased tensions.
However, there's an inherent risk that a ceasefire or de-escalation in any of these situations could lead to a sudden decrease in oil prices. This potential for headline risk could see prices adjust quickly if, for instance, Ukraine and Russia move towards peace, the Houthis halt their maritime assaults, or a ceasefire is brokered between Israel and Hamas, reducing the current geopolitical risk premium embedded in the price of oil.
In mid-April, when WTI was trading around $88/Bbl, a geopolitical risk premium of $5-10/Bbl was estimated to be priced in due to the Middle East tensions. This premium appears to have eased recently following Israel's limited retaliation against Iran. Meanwhile, the US, Egypt, and Qatar are pushing for new ceasefire talks as the region prepares for a potential Iranian attack on Israel.
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