EU-G7's price cap on Russian crude didn't disrupt any flows. Will the ban on fuels affect the refined product (and oil) market?
Oil posted a second consecutive weekly loss. March ’23 WTI lost $6.29 to finish at $73.39/Bbl. Friday’s decline of -$2.49/Bbl reinforced the market pessimism. Crude prices have continued to weaken despite expectations of a recovery in Chinese demand. Supply concerns have resurfaced with the EU’s looming ban on Russian refined products and its oil-price cap slated to take effect February 5.
EU and G7 nations have announced a $100/Bbl cap on premium Russian refined products like diesel and a $45/Bbl cap on cheaper products (i.e., fuel oil), though discussions are still ongoing. Russian diesel is still priced ($115-120/Bbl) above the G7’s proposed price cap level. While the ban on crude has apparently not impacted Russia’s seaborne crude exports because oil has traded below the price cap, the fuel ban might tighten supplies if buyers refuse to purchase at current levels that exceed the price cap. However, Russia’s resilience against Western sanctions might pan out as a less bullish component in 2023 if there aren’t anticipated levels of supply loss.
OPEC+ reaffirmed its commitment to current production arrangements amid uncertainties about demand in China and the impact of sanctions on Russian crude supplies. OPEC+ delegates reiterated their plan to maintain a cautious stance until there are more definitive signals that the market requires higher crude supplies.
The U.S. Fed announced Wednesday yet another, but smaller, rate hike, at 25 basis points, largely in line with expectations, and indicated more hikes could follow.
AEGIS believes price risk is skewed to the upside in 2023 as the risk of supply shortfalls outweighs demand risks. We do note that demand forecasts by many analysts have decreased in recent months, making the chance of a tight market less acute. AEGIS hedging recommendations for crude oil remain costless collars for 2023 and 2024. A collar would set a price floor but allow for more upside participation, compared to a swap, if prices realize higher. The upside exposure afforded by the structure makes it very popular among our clients in bullish markets. However, if prices have shrunk close to your budget levels, let’s instead talk about a mix of swaps and collars that will give you the precise amount of protection you need.
To see details on factors we believe are affecting oil prices and trade recommendations, click the "Read More" button on the Factor Matrix section in the AEGIS Research Module.
Crude Oil Factors
Geopolitical Risk Premium. (Bullish, Surprise) We decided to add this new factor, considering the recent turmoil hitting several countries in the eastern hemisphere. Most headlines are dominated by the Russian invasion of Ukraine, which has been the driving factor behind the prices. Concerns of supply constraints grew following the sanctions by the U.S. and UK. The European Union approved the eighth set of sanctions, including a ban on Russian oil imports, which came into effect on December 5. The G-7 nations agreed to cap the price of Russian oil exports, which also came into effect on December 5. They believe this price cap would restrict Russia's revenues to fund its war on Ukraine and keep the energy supplies flowing into the global market. The EU and G7 agreed upon a $60/Bbl price cap on Russian crude, which will be reviewed bi-monthly. The EU is working on a similar price cap mechanism to curb Russia's fuel exports. The ban on Russian petroleum products comes into effect on February 5. Additionally, Israel’s attack on an Iranian defense compound has escalated tensions in the middle east this week.
Trade Flows. (Bearish, Priced In) March '23 WTI lost $6.29 to settle at $73.39/Bbl this week. Prices this week weakened despite expectations of a rebound in China's demand after the relaxation of its Covid-zero policy. AEGIS also notes that the recent movement in prices was mostly driven by the price trend itself rather than the fundamentals. We see that trade flows have been affecting the price action in the commodity markets for the past few weeks, as the recent selloff in the crude market is attributed to major funds/firms liquidating. The oil market continues to struggle with low levels of participation, with open interest near multi-year lows. Cumulative open interest for WTI and Brent is at its lowest since 2015.
Iran. (Bearish, Surprise) The Iran nuclear deal negotiations concluded on August 8 after 16 months, and the EU has put forward a "final" text for the U.S. and Iran to consider. Iran responded to the U.S.'s response in the first week of September. U.S. Secretary of State Antony Blinken said that Iran has taken "a step backward" with its most recent response to a nuclear deal proposal and that an agreement in the near future is "unlikely." If an agreement is reached, the nation may increase output by nearly 1 MMBbl/d, perhaps starting in phases beginning in 2023. The possibility of ending or reducing Iran sanctions poses a downside risk to oil prices. This is one of the bearish non-economic factors that could pressure oil prices in 2022. Iran's production has risen to about 3.8 MMBbls/d in the expectation that sanctions will be eased soon. Some analysts estimate Iran is already exporting roughly 1 MMBbl/d despite the sanctions and doesn't disclose data for its official oil exports.
Russian Supply. (Bullish, Surprise) The Russian invasion of Ukraine has not yet resulted in a major shortage of oil on the market. Despite this, prices escalated because of the news, mainly to fears that sanctions against Russia would stifle energy exports. It is presently unknown how sanctions would affect energy flows or how long any potential supply disruptions will continue. Russia's total petroleum exports are estimated to be around 7 MMBbl/d, and the absence of even a portion of this supply, given that Russia is the world's third-largest supplier of oil, would be a significant influence in driving up prices. China and India remain to be the biggest buyers of Russian crude. The new sanctions and price cap are estimated to risk 0.5 to 1.5 MMBbl/d of Russian oil production. Additionally, the ban on Russian fuel exports will come into effect on February 5.
Oil/Product Inventories. (Bullish, Priced In) Crude and refined product inventories in both the U.S. and abroad are extremely low. Crude data is usually on a several-month lag. IEA data shows that OECD inventories were at a seven-year low in November. Since then, the oil market has likely remained in a supply deficit, so inventories are surely lower now, as evidenced by the massive backwardation in the forward curve. According to several shops, the global supply-demand balance is likely to hit a surplus at some point in 2022; however, volatility will likely be heightened with inventory levels at inadequate levels to serve as a "shock absorber" for prices. Distillate fuel inventories in the U.S. are 21% below the five-year average for this time of year. Meanwhile, exports continue to be high as refiners attempt to address global shortages brought on by the pandemic's quick recovery and the disruptions caused by Russia's invasion of Ukraine.
Supply Chain. (Bullish, Priced In) U.S. producers are struggling with supply chain disruptions, such as a shortage of workers, and equipment, a scarcity of sand for fracking operations, and high metals prices, to take advantage of increased global demand and high oil prices. These constraints could influence driving the prices up.
Government Intervention. (Bullish, Surprise) The United States announced the largest release from the Strategic Petroleum Reserve, totaling 180 million barrels or 1 million barrels per day over a six-month period beginning in May 2022, which was the biggest mover in prices. In addition to this, the IEA member countries announced another 120 million barrels, including the U.S.'s share of 60 million barrels. These SPR releases aim to reduce supply disruptions; therefore, they have a short-term bearish effect on oil prices. The 220-MMBbl draw from the U.S. emergency oil reserve since November 2021 has finally concluded. The SPR now stands at 371.6 MMBbls, its lowest since 1983. However, the Biden administration is negotiating purchases to refill the reserve at a $70/Bbl oil price. The Biden administration rejected the first batch of bids for the replenishment of the SPR after deciding that the offers it received were either too expensive or did not meet the required specifications. According to sources with knowledge of the situation, the DOE will postpone the purchase that was initially scheduled for next month but will stick to a program that accepts fixed-price offers.
Economic Slowdown. (Bearish, Mostly Priced In) Higher global energy prices might increase the potential for an economic slowdown. Macroeconomic uncertainties could pressure oil demand and, therefore, oil prices in 2022. According to the EIA, U.S. real GDP declined by 2.8% in 2020, and they estimate U.S. GDP increased by 5.9% in 2021. They estimate GDP has risen by 1.8% in 2022 and are forecasting it would fall by 0.1% in 2023. While that doesn't sound all too bad, the main takeaway is that crude oil demand growth would likely slow with GDP, and if supply growth outpaces demand growth, then you would find yourself in a structurally weaker market. U.S. CPI, an indicator of household goods inflation, showed the annual inflation rate fell for the sixth consecutive month to 6.5% from 7.1%, its lowest level in more than a year. Additionally, with the S&P 500 down almost 25% year to date, concerns about an economic slowdown are growing. The U.S. January jobs report indicates that the jobs market is stronger than expected, with employers adding 517,000 in January. Crude prices weakened following reports of strong U.S. jobs data.
OPEC+ Quotas. (Bullish, Slightly Priced-In) The OPEC+ (OPEC plus collaborating countries) “cut” announced on October 5 was a reduction of their production quotas of 2 MMBbl/d, or roughly 2% of global consumption, in an effort to stop the decline in oil prices. Saudi Energy Minister Prince Abdulaziz Bin Salman said that unless the market changes, the supply curbs will be in place through December 2023. AEGIS notes that even if the quota target is reduced, the actual production loss may be much smaller (1.0-1.1 MMBbl/d). Many OPEC+ members, including Russia, are already vastly underproducing compared to their quotas. This policy of quotas, which had been in place since mid-2021, has been revised in light of a decline in Russian output due to additional sanctions.
Since the pandemic began, OPEC has managed oil markets conservatively and allowed global inventories to be depleted, supporting oil prices. Recently, the narrative has changed, and many analysts are now questioning how much spare capacity the group really has left. Several countries, such as Angola and Nigeria, have underperformed relative to their quotas. These shortfalls have exacerbated recent market tightness.
COVID-19. (Bearish, Priced In) China's oil demand has been severely affected this year by strict COVID-19 control measures. Reduced mobility has hindered economic activity and, therefore, consumption. China eased its Covid restrictions and announced a slew of economic measures to boost its economy. When the country completely emerges from the lockdowns, its oil demand is expected to rise, putting extra strain on a market that has already tightened dramatically since Russia invaded Ukraine. Chinese oil consumption is expected to hit a record high this year. According to the median prediction of 11 China-focused consultants surveyed by Bloomberg, daily demand, which decreased last year, will increase by 0.8 MMBbl/d in 2023. China’s demand is important as it is nearly half of the global demand growth in 2023, which is expected to grow anywhere from 1.0 to 1.7 MMBbl/d.
USD. (Bearish, Priced In) The U.S. dollar's value has fallen to its lowest in nearly seven months. The movement in DXY was one of the bullish factors affecting crude prices this week. A weaker dollar can cause foreign buyers of dollar-denominated commodities to pay less for the same amount of goods. Fed Chairman Jerome Powell provided hawkish guidance that the Fed will soon begin winding down the emergency economic stimulus program and announced U.S. Federal Reserve raised rates by 50 basis points in December.
Non-OPEC Production. (Bearish, Surprise) Many prominent research groups (EIA, IEA, OPEC) think non-OPEC production, dominated by the U.S., will increase in 2022. If these forecasts come to fruition, it would have a slightly bearish impact on oil prices if the market were otherwise well-supplied. EIA forecasts the 2023 non-OPEC production to increase by 0.5 MMBbl/d.
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