Peaking oil prices, soaring inflation, and slackening global economic growth make a perfect recipe for a fall in oil consumption. Prior to Russia’s Ukraine invasion, there was a clear consensus on a strong global demand. However, now there is a strong probability that oil markets will tilt towards a minor surplus rather than the perceived wider deficit.
It is no surprise then that high oil prices are already leading to a slowing of both diesel and gasoline sales in various economies. We sense that oil prices have not yet fully factored in the demand erosion from high oil prices amid the difficult economic situation in China. Even as GDP growth projections are being revised downward across developed and emerging economies, the demand for transport fuels and petrochemicals are likely adversely affected.
Demand-supply dynamics
Global oil supply in Q3 2022 is projected to be around 101.2 mbpd, including 1.3 mbpd of global strategic reserve releases. Obviously, there is a downside risk to this forecast, given the supply developments and OPEC’s failure to meet targets. Saudi Arabia and the UAE are the only OPEC producers with spare capacity; however, there is still no indication if Saudi is willing or able to produce above the 11 mbpd. Nevertheless, the demand side of the equation is discounting a possible global recession into H1 2023. China’s lockdowns probably cost it around 1 mbd of demand losses and as of now, it is unclear whether the country will even be able to recover those losses in H2 2022. Q3 2022 global demand is projected at 99.6 mbpd, implying a fairly wide surplus of 1.6 mbpd for the current quarter.
The Ukraine war and Covid lockdowns in China continue to make oil markets volatile. There is great uncertainty on how Russian oil flows will take shape over this year, given the EU endeavour to impose an embargo by this year-end. Certain economies have already sanctioned Russian oil which is shaping a tectonic change in global oil movements. Russian oil is now diverted to China, India and South-East Asia, compensating for the large loss of the European market. We think that Russian output losses could eventually total 1.5 mbd; however, the IEA claim of 3.0 mbd is unlikely to be reached. We think the losses will be limited, as more Russian volumes are redirected from Europe to Asia.
The Russia angle
Though Russia will continue to divert the European supply to Asia, there are certain limitations to this rerouting. For one, it takes much longer for the crude to reach Asia than it takes to reach Europe. Secondly, Russia may not have enough ships to send all stocks to Asia, as most of them will not have insurance to set sail. Even if the question of faster access can be resolved given the abundance of port options, the ships may not be in a position to refine the sulphur-rich Russian oil. Clearly, a complete sell-off of Russian oil to Asia is impossible. Russia will ship to the extent possible, but there will be a drop in Russian supply due to storage constraints from inventory pile-ups.
In consequence, Russia may reduce production, and the partial deficit may be pumped up by US or OPEC nations. The coordinated release of strategic oil reserves by the US and other economies has mitigated supply tightness to an extent, adding around 1.3 mbpd of supply to global markets. EIA projections state non‐OPEC producers will increase output by 12 mbpd in 2022 from 2021 levels, with most of the US production rise seen during H2 CY22. Canada, Brazil, Norway, Argentina and Guyana are also predicted to show output gains during H2 this year.
The demand erosion and recovering supply will eventually tilt the oil price trajectory lower. The ongoing Russia-Ukraine war will keep oil prices elevated, but they are unlikely to runaway to $150/bbl; rather they may hover around $90105/bbl. There is no denying the fact that the market is facing a peculiar situation, where supply disruptions and fear of a possible looming recession juxtapose. Given the contrast of lower demand expectations and the reality of a few supply shortfalls, markets face a strange situation of price decline in upstream oil, coupled with tightness in the supply of refined products. We see the market could work its way down and settle towards $90 for Brent, though a major downside below $90 seems highly unlikely.
The author is Head – Institutional Equities, YES Securities