You don’t have to be a Nobel Prize winner in economics to know that the two basic influences on the price of oil, or any commodity for that matter, are supply and demand. That is the stuff of the most basic economic theory, and I would hope that anyone who trades or invests in energy related securities understands it. However, understanding the theory doesn’t always help with interpreting and analyzing what is happening in energy markets or with predicting what will happen. Reality and academic theory are often two very different things.
In theory, it should be possible to look at influences on supply and demand, weigh them against each other, and then make a prediction. That is what I and every other trader and investor attempt to do every day, after all. The problem, though, is that while one thing is moving or changing, others don’t stay static. So, at times, we get to where we are now, where there are factors on both the supply and demand side of the equation that are currently or could soon have a big impact on the price of oil, and their power and impact must be weighed against one another. That is why I do an occasional analysis of each side of the equation.
So, what are those factors, and what are they saying right now about oil prices?
Influences on Supply
Geopolitics and the Middle East: This is the one that is in the news right now, after the vicious Hamas…
You don’t have to be a Nobel Prize winner in economics to know that the two basic influences on the price of oil, or any commodity for that matter, are supply and demand. That is the stuff of the most basic economic theory, and I would hope that anyone who trades or invests in energy related securities understands it. However, understanding the theory doesn’t always help with interpreting and analyzing what is happening in energy markets or with predicting what will happen. Reality and academic theory are often two very different things.
In theory, it should be possible to look at influences on supply and demand, weigh them against each other, and then make a prediction. That is what I and every other trader and investor attempt to do every day, after all. The problem, though, is that while one thing is moving or changing, others don’t stay static. So, at times, we get to where we are now, where there are factors on both the supply and demand side of the equation that are currently or could soon have a big impact on the price of oil, and their power and impact must be weighed against one another. That is why I do an occasional analysis of each side of the equation.
So, what are those factors, and what are they saying right now about oil prices?
Influences on Supply
Geopolitics and the Middle East: This is the one that is in the news right now, after the vicious Hamas terrorist attacks on Israel prompted a military response that is also quite ruthless. There is now a “hot” war there after a few years of relative peace, and oil has traded higher as a result. So far, there has not been any major impact on supply and the move up is in response to the possibility of the current situation leading to a wider conflict.
Two things strike me here. First, the threat of disruption in the region is ever present and has been for millennia. It may be perceived as being higher than usual right now as the two sides of the Palestinian divide are actively and openly killing each other, but has it really changed? The hatred is so deep and abiding that we were only ever one act of extremist violence away from escalation, and given the level of extremism, that was never far away.
Second, I have to believe that escalation to a wider, region engulfing war that would have a big impact on the supply of oil isn’t going to happen. With Israel having nuclear weapons and rumors at various times of Iran, Libya and Syria being at various stages of development of them, and with the complexity of alliances in the region and America’s position within them, the consequences should it do so are just too horrific to contemplate.
The threat to the supply of crude here, therefore, is real, but not as big as the jump up in oil prices might suggest.
North America: Contrary to what some politicians and news sources would have you believe; the US supply of oil has increased, not decreased dramatically, under President Biden and is currently at record levels. Remember, though, that that climb has come off of extremely low levels during the pandemic, and that global demand has increased significantly in that time too. Given that, the Biden administration’s reluctance to approve new drilling and pipelines that was evident at least early in his Presidency have had an impact that is still resulting in a tight market and therefore higher prices.
The damage done to his reelection chances by inflation has caused a sudden move away from the belief that big oil companies are evil incarnate, but some damage to the global supply of oil has already been done and an approaching election makes a move to the left to shore up his base a distinct possibility.
OPEC+: Even as that short supply elsewhere has played out, OPEC and their allies in the OPEC+ group have maintained a hard line, increasing supply from the pandemic lows at a much slower rate than market conditions would indicate is appropriate. There are several reasons for that. It is in their economic interest to make hay while the sun shines and get as much for their reserves of what is after all a finite resource as they can at any given time. But there is also a political element, with many members of OPEC+ seeing inflationary pressure on the US and its government as a good thing and being happy to do whatever they can to increase it.
Overall, supply is tight, with the risk being that it will tighten even further. That is a strong bullish influence on crude.
Influences on Demand
Interest Rate Hikes: The Fed and other central banks around the world, after an extended period of ultra-low rates, began to reap what they sowed a year and a half or so ago as inflation took hold in major economies. They felt the need to raise rates to combat that but, as Jay Powell, the Fed Chair, said in an interview this week, slower economic growth is needed if those efforts are to succeed. So far, there hasn’t been a major slow down as rates have risen, but Powell’s words this week and the time lag that normally exists between monetary policy changes and their impact on an economy make it possible that the Fed will continue to hike, possibly to the point where they prompt an actual recession in the US that will almost inevitably spread to the rest of the world.
Chinese Growth: To some extent, China is one country that exists outside of the sphere of influence of US monetary policy, but even if we assume that they will not be too badly harmed by a US slowdown, their economy faces some major problems of its own. The real estate market there got out of hand in the pre and post pandemic boom, with borrowing also growing at an alarming rate as a result. There are signs that that bubble is deflating as property prices have fallen dramatically and several high profile developers and investors are in trouble.
China is the world’s largest consumer of oil, so if those problems spread, as they easily could, the impact on oil demand will be huge. So far, they have avoided disaster, with GDP growth in Q3 coming in higher than forecast, but the days of 8-10% growth in China driving global growth and consumption are long gone
Electrification and Alternative Energy: When most people think of threats to demand for oil, this is one of the first things that comes to mind. EVs are increasingly common and the push towards renewable energy is visible all around us as solar and wind farms are nothing if not noticeable. However, while these things will have a big impact over the next few decades, they aren’t impacting pricing right now. On a long term basis oil has continued to increase despite them, and their long-term impact has been priced into crude for a long time. So, absent any massive new technological breakthrough in the next couple of months, EVs and renewable energy can be ignored with regard to the price of oil.
On the demand side, then, it is a matter of timeline. Right now, demand is holding up well but, in the coming months, there are some big downside risks that are obvious for all to see.
So, the logical conclusion here is that, with tight supply and fairly steady demand as of now, crude can continue to catch a bid and move higher. At some point, though, a global slowdown, whether led by the US, China, or somewhere else, is starting to look almost unavoidable. By early next year, I would be very surprised if WTI were trading higher than the current levels around $90 and a substantial decline before then is distinctly possible.
Usually, as regular readers will know, I like to look for a somewhat contrarian view; something that the market may have missed or for some reason is ignoring, but this conclusion doesn’t fit that bill at all. It is, in fact, pretty much in line with the conventional wisdom, but it is the logical conclusion after an analysis of current supply and demand conditions. That is why I do this exercise periodically, though, so that I can come to a logical conclusion based on the facts, regardless of my desire to be different or my preconceptions. So, that, strength for a while then weakness before too long, is the view that will guide my trading and investing strategies until circumstances change.