Oil markets put a question mark on the soft landing expectations

Oil prices have sold off meaningfully from their recent highs. Brent and WTI crude oil lost $4.51/bbl and $4.89/bbl, respectively, from $91.17/bbl and $86.91/bbl (see Exhibit 1) at the time of writing. 

Exhibit 1: Oil prices corrected sharply from their peaks

$/bbl

Source: Goldmoney Research

It wasn’t just oil flat prices that came under pressure. Time-spreads in both Brent and WTI are also sharply off their highs. For example, the 6-month Brent time-spread (June-December) is down to $3.59/bbl at the time of writing, after trading as high as $5.61/bbl just two weeks ago (see Exhibit 2). Oil time-spreads tend to reflect physical tightness in the market. When oil availability is tight, time-spreads tend to trade in backwardation, meaning prompt prices trade above forward prices. A market with ample supplies is trading in contango, where prompt prices trade below forward prices. 

Exhibit 2: Oil times-spreads came sharply off their highs

$/bbl

Source: Goldmoney Research

This comes against the backdrop of the highest geopolitical risk in decades. Iran is blaming Israel for a missile attack on the Iranian embassy on 1 April 2024 that killed sixteen people. Seven were members of the Islamic Revolutionary Guard Corps, of which one was Brigadier General Mohammad Reza Zahedi, a Quds Force commander of the IRGC. Israel never officially confirmed their responsibility of the attack. Iran retaliated a few days later by launching its first direct attack on Isarel by launching over 300 drones, cruise missiles and ballistic missiles, most of which were intercepted by the US, UK, Jordan and Israel’s air defenses.

While US president Biden subsequently urged Israel not to further escalate the situation, Isarel announced it would not leave this Iranian attack unanswered and all options were on the table. It is unclear whether the three drones shot down over the central city of Isfahan by Iran mark the Israeli response. The kind of response Israel chooses, if any, is crucial. Large scale direct attacks on Iranian territory would almost certainly escalate the conflict further.

This carries the risk that this evolves into a more regional conflict. At the very least, Iranian oil exports are at risk, but also oil shipments through the Strait of Hormuz. This would have a dramatic impact on global oil supplies. Iran currently produces around 4.5mb/d of crude oil and condensates (see Exhibit 3). We estimate that total OPEC spare capacity is slightly below that.

Exhibit 3: Iranian petroleum production is over 4 million b/d

Thousand b/d

More importantly, around 20 million b/d of oil is shipped through the Strait of Hormuz (see Exhibit 4). That’s about 1/3 of all oil traded in the world. Iran has threatened to target the strait of Hormuz in the past and it would certainly have the ability to do so.

Exhibit 4: One third of all oil traded in the world transits the Strait of Hormuz

Source: Google Maps, Goldmoney Research

But this conflict is not the only one affecting oil markets. While sanctions on Russian oil and petroleum product exports on the back of the Ukraine invasion have done very little to reduce Russian supplies (see Exhibit 5), Ukraine’s new strategy targeting Russian energy production has a much higher likelihood for disruptions. So far, Ukraine targeted mainly Russian refineries. We estimate that up to 1 million b/d of Russian refining capacity has been affected so far. Other targets could be Russian export terminals. However, it would probably be more difficult to do lasting damage with a single drone.

Exhibit 5: Sanctions on Russian oil exports had little impact on production, but Ukraine’s new strategy targeting Russia’s oil infrastructure might

Million b/d

Source: JODI, Goldmoney Research

This hadn’t gone unnoticed in Washington. There have been reports that the White House urged Ukraine to stop targeting Russia’s energy infrastructure. This came on the back of sharply higher prices for crude oil. Initially, this plea had gone unheard as Ukraine continued targeting Russian refineries afterwards. But in recent weeks, the attacks seem to have halted. How long that will last is another question.

Even without any disruptions to oil supply from any of these geopolitical hotspots, oil supply from OPEC is sharply lower. OPEC+ decided to reduce oil supply in 2023 and has extended these cuts multiple times (see Exhibit 6). In their most recent decision, OPEC decided to extend all cuts to the end of 2024.

Exhibit 6: OPEC reduced output by more than 1.5mb/d already

Thousand b/d

Source: JODI, Goldmoney Research

Yet despite all of that, oil is not able to remain above $90/bbl. We believe this could indicate a problem with demand.

Recent price action is one indicator that demand might be struggling. Another visible indicator of weaker demand however is inventories. Crude oil in inventories declined sharply in 2023 on the back of the previously mentioned OPEC cuts. But more recently, oil inventories have been increasing at a rapid pace (see Exhibit 7). This is particularly concerning as oil production in the US had taken a hit from the extremely cold weather in January. So far, US oil production has yet to fully recover, something we expect to happen over the coming months.

Exhibit 7: US oil inventories have been sharply increasing over the past months, despite a 30mb production loss in January

Thousand barrels

Source: EIA, Goldmoney Research

A further indicator of demand weakness are refinery margins and product spreads. Middle distillate cracks and time-spreads rallied strongly at the beginning of the year, driven by the disruption of shipments through the Suez Canal and the Ukrainian attacks on Russian refineries. While the Suez Canal remains blocked and the Russian refineries struggle to get back online, middle distillate cracks have declined sharply from their peak and time-spreads are now in contango (see Exhibit 8).

Exhibit 8: US NY Harbor ULSD spreads flipped into contango recently

$/gal

Source: Goldmoney Research

Oil agencies such as the IEA and EIA, Wall Street banks as well as independent Research companies are all predicting global oil demand to grow between 1.2mb/d to over 2mb/d in 2024. Most forecasts are around 1.5mb/d or higher. 1.5 million b/d oil demand growth equates to around 1.5%. At the same time, the IMF predicts global economic growth to be just 3.2%, which we think is about consensus at Wall Street.

In contrast, over the 10 years following the global financial crisis until the Covid years, oil demand was growing by around 1.6% on average. However, global economic growth averaged around 3.8% during that time. Hence, oil demand growth forecasts seem overly optimistic given the consensus on global growth expectations.

In addition, 3.2% global economic growth requires a soft landing. But the global economy isn’t in great shape. Global economic growth in 2023, was already just 3%. This despite the restart of the Chinese economy and some one-off post Covid base effects in the rest of the world. In 2024, the world is facing a struggling China and several European economies are close to a recession. For example, China reported its GDP numbers for 1Q24 on Tuesday 16 April. The numbers at face value looked better than expected. But the problem was that March data looked much worse than expected. Thus, the ample stimulus provided by the Chinese government helped the Chinese economy somewhat, but if the March data is any guidance, this effect has already fizzled. This is important because China accounted for over 70% of oil demand growth in 2023.

The European economy is not doing particularly well either. Some European economies are already in a recession. Recent PMI data showed some signs of improvement, but we have yet to see whether Europe manages to get out of a recession at some point, or its only at the beginning.

On top of that, resilient economies like the US will eventually be impacted by higher interest rates. The US economy has been very strong in 2023 and continues to be strong so far. But oil demand has not reflected that since the beginning of the year. Diesel demand is down -3.5%, gasoline down -0.2% and overall petroleum product demand is down -0.6%[1] (see Exhibit 9).

Exhibit 9: US oil demand in 1Q24 is lower than last year

Thousand b/d (Gasoline, Middle Distillates, Jet Fuel and Residual Fuel)

Source: EIA, Goldmoney Research

Hence, the current consensus global growth forecast of 3.2% is in our view a best-case scenario. A higher number seems entirely implausible. But scenarios with lower growth seem entirely plausible. 

In a nutshell, global demand for oil products seems to be struggling in recent weeks. Global economic activity and oil demand growth are highly correlated. Given the building inventories, we estimate that global oil demand growth has fallen below 1mb/d in 1Q24. This implies that global GDP growth had dropped below 3%.

While the economy might be slowing down, the Fed is busy with something else: Supercore inflation. The Fed’s new favorite inflation measure that focuses on services, shows inflation is accelerating again (see Exhibit 10). On top of that, the rally in oil prices in 1Q24 will also add inflation pressure. Hence, the Fed might be increasingly hesitant to cut rates even as the global economy is slowing down. In our view, this increasingly reduces the odds of a global soft landing. 

Exhibit 10: US CPI Supercore inflation is already rising again

% year-over-year

Source: Goldmoney Research

[1] Demand for "other” oil products and propane excluded.