Oil prices slump as receding price-cap threat unmasks worsening demand
Global oil prices have tumbled more than 20% as the threat to production from the G7 Russia price cap has receded allowing traders to refocus on the deteriorating outlook for consumption.
Front-month Brent futures prices have slumped to less than $78 per barrel from a recent high over $98 just a month ago on Nov. 4.
Brent’s six-month calendar spread has swung into a contango of 50 cents per barrel from a backwardation of more than $8 over the same period.
The collapse of spot prices and spreads is consistent with a cyclical downturn in the oil market and the onset of a business cycle slowdown or recession.
Chartbook: Global petroleum price cycle
The explosive cyclical upswing in both the economy and oil that began after the first wave of the coronavirus and lockdowns in the second quarter of 2020 appears to have peaked in the second quarter of 2022.
Since then, most indicators have pointed to decelerating economic growth and oil consumption, with outright declines in some regions: * The United Kingdom and European Union have experienced themost severe slowdown, entering recession as a result of Russia’sinvasion of Ukraine, sanctions, and their reliance on expensiveenergy imports. * China has also experienced a sharp slowdown and is likelyin recession as a result of the cycle of city-level lockdownsimposed to control the spread of coronavirus. * The United States has experienced the mildestdeceleration, concentrated in consumer spending, manufacturingand freight transportation, though it has avoided recession sofar.
The result has been slower petroleum consumption growth, relieving downward pressure on inventories and taking much of the heat out of prices.
High oil and other energy prices themselves contributed to the broader economic slowdown through their impact on inflation, interest rates and consumer spending.
Global oil and energy consumption have been falling since the third quarter under the impact of exceptionally high prices and a slowing economy.
But the impact was initially masked by concerns about the planned introduction of the price cap on Russia’s crude and refined products exports.
Traders anticipated the price cap and Russia’s response would cut production by more than the economic slowdown cut consumption.
Fears about the impact kept prices elevated, and even increased them from late September through October, despite the increasingly poor outlook for the economy.
From early November, however, it became increasingly clear the cap would be introduced at a relatively high level with a relaxed approach to enforcement.
The underlying deterioration in consumption was unmasked, leading to a sharp drop in prices and spreads, consistent with past downturns in the global business cycle.
The rapid decline in prices has likely been anticipated, accelerated and amplified by the readjustment of investors’ positioning.
Hedge funds and other money managers cut their combined position in the six most important petroleum futures and options contracts by the equivalent of 190 million barrels between Nov. 8 and Nov. 29.
Most of the reduction was concentrated in Brent crude, where positions were cut by the equivalent of 139 million barrels over this 21-day period.
Investor positions in Brent were cut to just 99 million barrels (6th percentile for all weeks since 2013) on November 29 from 238 million barrels (50th percentile) on Nov. 8.
Most fund positions are concentrated in contracts nearest-to-delivery, where liquidity is greatest, so the liquidation has weighed on the front-end of the futures curve especially hard, accelerating the shift into contango.
LESSONS FROM 2014
The recent slump in oil prices shares some, though not all, characteristics with the slump occurring in the third quarter of 2014 (“A brief history of the oil crash”, Reuters, January 2015).
In 2014, the deteriorating consumption environment was also masked by the threat to production from civil war in Libya and the rapid advance of Islamist fighters towards the oilfields of northern Iraq.
Once those threats began to recede in July, spot prices and calendar spreads fell rapidly, with the move accelerated and magnified by the liquidation of formerly bullish hedge fund positions.
The inevitable slide in prices turned into a slump when Saudi Arabia, Russia and U.S. shale producers all declined to cut production and fought a volume war for market share.
The end of the U.S. shale revolution means that a volume war for market share is less likely to be fought in 2022/23, so prices are unlikely to fall as far this time around.
It is also probable recent hedge fund liquidation has exaggerated the recent fall in oil prices creating some headroom for a short-term rebound; positions are now unusually low.
But the underlying dynamic is straightforward and easily explained: as production threats receded the underlying deterioration in the consumption environment was unmasked causing a sharp downward correction in prices and spreads.