Oil Weekly: Eight Points on the Oil Market for H2 2023

Summary

• We are neutral on crude as industrial demand is slowing. However, OPEC+ production cuts are beginning to tighten the physical market.
• Dubai crude now trades at a premium to Brent, encouraging global refiners to increase imports from elsewhere (e.g. the US) or draw down inventories.

We Are Neutral on Crude

2023 has been an interesting year for the oil market, largely defying market consensus for a bull market driven by China’s reopening and supply cuts from Russia and other sanctioned countries.

With Brent currently hovering above $77 a barrel, we think it continues to trade in its recent range, with chances of pushing back towards $80 if global inventories continue to draw down as expected, following the imposition of ‘voluntary cuts’ by OPEC+.

Here is a summary of how we view the oil market:

1. Supply Cuts Are Already Impacting the Oil Market

While the price of the global benchmark for oil, Brent, has remained in a tight range in recent weeks, we can see beneath the surface that OPEC+ cuts are beginning to have an impact on the oil market.

First, Dubai crude has begun to trade at a slight premium to Brent for the first time since 2020 (Chart 1).

Why? Following the decision by OPEC+ to cut production, Saudi Arabia and other OPEC countries also raised their official selling price (OSP), making their crude less attractive relative to other blends. This means it is now more attractive for global refineries to import crude from the US for instance, or draw down existing inventories, than increase purchases from Dubai.

We have also seen a reversal in the September – December (U3Z3) calendar spreads in Brent and WTI, which were heading rapidly into contango. This coincided with recent large inventory draws in the US. Note: Q4 is when consensus expects the largest period of under-supply, so seeing calendar spreads move slowly into contango would be a very bearish sign for the oil market. Dubai calendar spreads did not weaken to the same extent, but now both markets have moved back further into backwardation (Chart 2).

2. US Crude Inventories Are Falling (Finally)

US commercial crude and product inventories are declining again and at a faster rate than we would seasonally expect. This is positive for Brent as it implies that the balance between demand and supply has shifted favourably in recent weeks, where inventories have fallen by 8mn barrels (Chart 3).

3. However Chinese Inventories Have Risen Sharply

Chinese crude inventories are estimated to have increased by 0.73mn b/d this year, supported by rising crude exports. For context, Chinese crude inventories rose by 0.74mn b/d last year, when crude imports were much lower.

We also see crude at Chinese ports back near the post-Covid highs (Chart 4). This suggests that should oil prices rise, China is in a position to materially reduce oil imports and draw down from inventories. This caps any large upside in oil prices this year.

4. Saudi Extends Production Cuts

This week we saw Saudi Arabia decide to extend their 1mn b/d production cut (which came into effect at the start of July) to August. This takes Saudi’s production to c. 9mn b/d, which is the lowest since 2021, and 2011 before that – truly crisis levels of production cuts. Importantly, Saudi emphasised that cuts could be extended beyond August as they try to dominate the market narrative and tighten the physical market.

5. Russia to Cut Crude Exports

Just after Saudi’s statement confirming the extension of their production cuts to August, Russia’s Novak stated that they will cut crude exports by 0.5mn b/d in August.

Two points here. First is the emphasis on cutting exports rather than production. Exports can be tracked far easier than production, which Russia has conveniently stopped reporting. Production cuts can also be easily gamed by coinciding reduced oil consumption at home while ensuring exports remain steady. Therefore, we think the probability of Russia following through is higher than in the past.

Second, Russia did not specify from what level Russian exports would be cut. For context, Russian seaborne exports averaged 3.4mn b/d in June, versus 3.8mn b/d in May (Chart 6). If Russian exports are cut from May levels, this only implies a further 0.1mn b/d reduction, which is unlikely to impact the oil markets significantly.

As a best-case scenario for OPEC, the combination of Russian and Saudi production cuts over July and August should reduce global inventories by c. 55mn barrels.

6. Global Manufacturing Activity Is Deteriorating

Despite services activity continuing to be robust globally, industrial activity continues to deteriorate, including in the US. The ISM Manufacturing PMI is now below 50, signalling contraction. Base effects from last year are impacting the assessment of the change in the oil price this year. However, if industrial activity remains weak, diesel and petrochemical demand is unlikely to pick up, hurting the oil price.

7. US Gasoline Demand Picks Up

Following a disappointing start for US driving season after Memorial Day, US gasoline demand has picked up sharply in recent weeks. The most recent estimate of gasoline demand is c. 9.4mn b/d (Chart 8). So far, this demand looks real (i.e., it has coincided with a decline in gasoline stocks), which are back to dangerously low levels supporting gasoline cracks (Chart 9). Jet fuel consumption also remains strong.

8. Speculators Remain Bearish

Speculative positioning is increasingly bearish. Long positions make up 69% of total managed money positions, which is the lowest in three years. Similarly, managed money net long positions as a percentage of open interest are the lowest since April 2020.

Viresh Kanabar has worked in the UK financial services industry for over 8 years including in Consulting and Investment Risk. Most recently he launched The Macro Journal Substack where he puts out regular in-depth reports covering all areas of global macro.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)