The oil market has been showing some confusing signals of late, which has contributed to extra volatility over the summer. Yesterday was a microcosm of that, with a couple of surprising events. Citigroup analysts advised traders to short crude prices after the summer, suggesting that demand will diminish. Following the release of the recommendation, crude prices popped back up above the key psychological level $80/bbl.
Of course, the summer isn’t over yet, so Citi’s advice wasn’t supposed to be for immediate effect. So, could they be right about the end of September seeing crude prices taking another excursion lower? Part of the problem in forecasting crude prices is that they are subject to a lot of geopolitical interference. And what politicians decide to do isn’t aligned with market incentives.
Getting the forecasts wrong
Both the IEA and OPEC have been optimistic in their outlook for crude prices for the rest of this year, based primarily on expectations that China’s economy will surge forward. China is, of course, the world’s largest importer of fuel. But the recent data from the world’s second largest economy has been grim, pointing to deceleration. Economists are warning that China won’t reach its 5% economic growth target, which is below the 6% that the IEA is basing their forecasts on.
While OPEC has forecast increased demand this year, its members have behaved in a contrary fashion. Or, more specifically, its key member that has extra production capacity, Saudi Arabia. The world’s largest oil producer after the United States has cut its production targets each month in an effort to raise prices.
Keeping prices in a range
Saudi Arabia has the capacity to immediately throw an extra 1M bbl/day production on the market if demand were to increase. Meanwhile, China’s demand has been driven by stockpiling, not organic need for fuel. Which means that higher prices could prompt Chinese buyers to stop, and wait for more auspicious conditions. In other words, there are two big players that are essentially putting a “cap” on the upward trajectory for crude prices.
The problem for crude and CAD traders is that it’s not transparent where that cap is. No one knows at what price Saudi Arabia would be satisfied, and start increasing production. It’s even less clear at what price Chinese traders would consider it no longer a profitable investment to buy and hold crude. But such constraints don’t exist on the downside. The US had committed to buying up crude to replenish its SPR if the price fell below $70/bbl. But American buying has been in the low single-digit millions of barrels, a tiny fraction of US production, let alone global production.
The shifting outlook
Forecasts for crude demand are being shaken up by economic developments, but in the end, they might not be wrong. Chinese data has underperformed, but that has been more than compensated by demand from the US. Most economists now believe the US will avoid a recession, which could mean that the largest consumer of fuel in the world will keep on buying and supporting the price of crude.
The yield curve inversion in the US has been diminishing lately, which some analysts have taken as a sign that a recession might be avoided, particularly in light of the Fed’s GDPNow tracker forecasting Q3 GDP growing at an annualized rate of 5.8%. But, it’s not a foregone conclusion that the US will have a soft landing. After all, the yield curve tends to “de-invert” in the couple of months before the market takes its recession-starting dive. That could prove Citigroup right in the end.
