Oil Weekly: What Could Break the Range in Oil Prices

Summary

• The market now has increased certainty around China’s recovery and Russian oil supply.
• We lay out four scenarios for oil – continued range, jump in industrial demand, China recovery fizzling and a US hard landing.
• Our base case remains that Brent trades within a range around $80 a barrel, but higher industrial demand could see a breakout to the topside later this year.

Expectations Entering 2023

As we entered 2023, only two things mattered to the oil price outlook:

1. How strong China’s recovery would be as they exited zero-Covid.
2. How much supply would be lost due to the sanctions on Russia.

Combined, these factors had the potential to swing the global supply/demand balance by up to 2mn b/d.

Five months in, we have much more clarity about both factors.

The China Recovery

Our China growth tracker shows the recovery has been strong. Air travel has bounced back, but the impulse to jet fuel is likely lower than usual due to more of these flights being domestic than international. For the latter, miles travelled per flight remains 50% lower than in 2019.

Like the rest of the world, Chinese manufacturing activity has struggled as the global economy keeps shifting from goods to services. This has impacted demand for diesel and other petrochemicals. Bloomberg also reported trucking activity has fallen sharply recently too.

Overall, consensus indicates an increase in Chinese oil demand of 0.7mn b/d, which seems reasonable.

Russia Oil Production

Russian oil production remains robust this year. Russia has found alternative buyers for crude in India and China and multiple buyers for refined products, effectively rerouting oil global trade flows in a few months.

Despite fears over Russian production, we believed it was clear from February that Russia was following the template laid out by Iran to ensure they can keep selling oil. As expected, many forecasters have increased their estimates of Russian production for 2023, in line with our view.

Oil Market Dashboard

Before laying out scenarios, we summarize the key factors impacting the oil price – we will share this dashboard monthly.

Table 1 shows the oil market’s drivers remain constructive (bar industrial demand proxies). Brent trades below our commercial inventories-based model, which is flagging a price of $80 per barrel, and the crude curve across WTI and Brent remains in backwardation.

Positioning looks broadly neutral. Managed money net-longs remain near their historical average at 8% of open interest. However, net longs as a percentage of total managed money positions look elevated.

Four Oil Scenarios for 2023

Scenario 1: The Slow Grind

The slow grind is the regime of the last few months. Speculative flows rather than strong changes in fundamentals have driven oil prices, which remain rangebound.

In this scenario, we maintain our position that Brent is likely to trade within its existing range of $75-85 a barrel.

Despite China emerging from zero-Covid, industrial activity has remained weak globally (Chart 1). Rebounding services support gasoline demand (when traveling to restaurants) and jet fuel (more flights), but diesel demand has remained frail.

This scenario remains our base case as central banks continue to tighten, capping economic upside and preventing growth up-cycles from broadening to manufacturing.

In this scenario, the upside to oil prices stems from the supply side as production cuts from OPEC+ are likely to impact the oil market in H2 as inventory levels keep depleting. So far, declining inventories are limited to the US; those in Europe and Japan remain elevated.

The downside in oil prices should also be capped, however, due to the increase in jet fuel demand and the seasonal rise in US driving miles during the summer. Gasoline inventories in the US are already tight, ensuring refinery margins stay elevated, supporting demand. Normalisation of gasoline prices following the spike after Russia’s war on Ukraine should support demand this year (Chart 2). 

Scenario 2: Industrial Activity Rebounds:

Diesel is the source fuel for 70% of trucking activity in the US (and 60% in China) plus most of the freight market. Recent US transportation-related data has confirmed the weakness in PMIs. Indices such as Truck Tonnage, AAR rail traffic, Cass Freight, and container shipments to LA and Long Beach have all fallen in recent months.

However, increased manufacturing activity driven by a need to restock inventories and increased goods demand could change this, adding material upside to the oil price. Manufacturing upcycles tend to be synchronised due to supply-chain linkages, so a rise in manufacturing PMIs globally would confirm a new oil bull market.

Scenario 3: The China Recovery Fizzles Out

Other more benign downside scenarios would stem from China’s recovery slowing. As discussed, China’s recovery is expected to add c. 0.7mn b/d to global oil demand this year.

The Chinese consumer will likely drive any weakness. Their excess savings have been materially lower than US and European counterparts. Weaker domestic demand is likely to impact gasoline and jet fuel demand.

We keep watching our mobility indicators but think this scenario is less likely to materialise due to demand preferences shifting from goods to services.

Scenario 4: Hard Landing

The global recession scenario currently seems unlikely due to the US consumer’s resilience and the improvement in global services activity. However, a hard landing would materially lower oil prices, likely back to $50 a barrel.

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.)