Special Situations Report: Have Oil Prices Reached Their Peak?

Special Situations Report Oil Prices Reach New Heights: Are We at the Peak?

According to the September IEA (International Energy Agency) report released for September 2023.

World Oil Demand

Oil demand is projected to grow by 2.2 million barrels per day (mb/d) in 2023, reaching 101.8 million barrels per day. Key drivers include increased consumption in China, rising demand for jet fuel, and petrochemical feedstocks.

Strong economic conditions in major energy-consuming countries, such as the U.S., have led to record high global oil demand in 2023.

In 2024, the demand is expected to grow by a more modest 990 kb/d, reaching 102.8 mb/d, due to below-average GDP growth and a structural decline in road transport fuel use in major markets.

Supply Factors

Saudi Arabia and Russia have extended voluntary production cuts through the end of 2023, creating a significant market deficit in the fourth quarter of 2023.

OPEC+ output has already decreased by two mb/d this year, partially offset by higher Iranian flows. Non-OPEC+ supply has risen by 1.9 mb/d to a record 50.5 mb/d by August 2023. World supply in 2023 will rise by 1.5 mb/d, with the United States, Iran, and Brazil being the main sources of growth.

Russian oil export revenues have increased due to higher prices despite lower shipments. Russia is chasing higher oil prices for several reasons, primarily driven by the need to replenish its military arsenal amidst declining oil exports. Russia is employing several tactics to increase its oil revenue. First, it is benefiting from higher global oil prices due to factors like production cuts. Second, Russia is focusing on selling more premium refined oil products, particularly diesel, by maximizing refining capacity. Lastly, it is exploring new distribution channels, including increased piped flows to select European countries and using the shorter Arctic route for oil shipments to China, in an effort to optimize distribution and reduce costs.

Refinery Margins

Refinery margins reached an eight-month high in August due to challenges in meeting the growing oil demand, particularly for middle distillates. Product cracks and margins reached near-record levels, driven by unplanned outages, feedstock quality issues, supply chain bottlenecks, and low stocks. Global refinery runs are projected to rise by 1.7 mb/d to 82.4 mb/d in 2023 and by 1.2 mb/d to 83.6 mb/d in 2024.

Oil Inventories

Global observed oil inventories decreased by 76.3 million barrels to a 13-month low in August, primarily driven by a substantial decline in oil on water. Non-OECD oil stocks decreased by 20.8 million barrels, with China experiencing the largest drawdown, while OECD inventories declined by 3.2 million barrels. In July, OECD industry stocks increased but remained below their five-year average.

Oil Prices

Oil prices traded in a narrow range in August, with North Sea Dated crude oil hovering around $85 per barrel. Price volatility reached multi-year lows. Prices surged higher at the end of the month, surpassing $90 per barrel for the first time in 10 months.

Analysts predict that oil prices could breach $100 a barrel in the near future due to strong demand, limited supplies, and the U.S. administration’s limited tools to control prices. SPR (Strategic Petroleum Reserve) levels are low, and the Biden administration pulled back an offer to buy six million barrels of oil for the Strategic Petroleum Reserve in August 2023. The administration also highlights that while higher oil prices boosts profits for oil producers, it may not lead to a significant increase in domestic production. The U.S. shale oil industry has become more cautious in its approach, focusing on returning cash to shareholders rather than rapid production growth.

Likely Outcome for Oil Prices

The EIA predicts:

Key Assumptions of the EIA Forecast

The key forecast for global oil markets and prices is driven by Saudi Arabia’s decision to extend a voluntary production cut of one million barrels per day (b/d) through the end of 2023. This extension is expected to lead to a decrease in global oil inventories, exerting upward pressure on oil prices. In the fourth quarter of 2023 (Q4:23), the Brent crude oil spot price is projected to average $93 per barrel (b), while prices should decline in 2024 to an average of $88/b as oil inventories build. The current assessment indicates that global oil inventories are falling by 0.6 million b/d in the third quarter of 2023 (Q3:23) and moderating to 0.2 million b/d in the fourth quarter of 2023 (Q4:23). OPEC+ production cuts are expected to keep global oil production below global oil demand, with the Brent spot price remaining above $90/b through the first quarter of 2024 (Q1:24) and averaging $87/b for the rest of the year.

Non-OPEC production growth, led by the United States, Brazil, Canada, and Guyana, is a significant factor in global production growth. Russia’s production is anticipated to decline slightly in 2024, while OPEC crude oil production is forecasted to decrease in 2023 but increase in 2024.

Investment Strategy

Historical trends spanning the past decade reveal that crude oil prices have faced consistent challenges in maintaining a position above the $90 per barrel threshold for extended periods. Typically, these periods of higher prices have been followed by corrective actions in the market. While there is a slim possibility that Brent Crude might briefly breach the $100 per barrel mark, it is improbable that such levels will be sustained. Recent price hikes, primarily attributed to OPEC+ production cuts, are anticipated to diminish in the near term, barring unforeseen risks. These historical patterns of price volatility present opportunities for short-term gains when adopting a bearish stance.

In essence, considering the existing supply-demand dynamics and potential consequences in financial markets, including potential political implications for Saudi Arabia’s long-term strategic objectives, shorting the USO ETF could be a viable investment strategy. Nonetheless, investors should exercise caution in the face of short-term market fluctuations and remain vigilant to changing conditions. It is worth noting that the trade offers an upside potential of 17% with a corresponding downside risk of 10%.

Other Risk

The reluctance of Saudi Arabia and OPEC to increase oil production, as they have done for previous American presidents during election cycles, poses a near-term risk to the view that oil prices will gradually decline. Historically, American presidents, including Barack Obama and Donald Trump, received timely increases in Saudi oil production to ease price pressures on oil markets in the lead-up to U.S. elections.

However, when President Joe Biden last sought similar support, OPEC+ chose not to raise production but, instead, implemented a substantial cut. This decision contributed to keeping oil prices above $90 per barrel, significantly higher than the 10-year average. The Saudi’s animosity towards President Biden and a desire to assist Republicans in the U.S. midterm elections potentially favors the re-election of Donald Trump in 2024

-Gowshihan Sriharan, CFA “The Rover.”