Oil has been one of the most confusing trades for all asset managers over the past 12 months.
Early this year, every analyst on Wall Street had predicted oil would run away to $150 to $200 a barrel, as there was seemingly "none of it" after the Russian invasion of Ukraine. Brent oil is now down 40% since the highs reached in May and it has settled down to $80 per barrel -- from highs of $135 per barrel. The bulls have not turned, and, despite oil falling by over 40%, the bulls are still firmly holding onto their thesis of oil remaining in short supply thanks in part to the clean energy transition mechanics.
Commodity markets, however, are all about finding the right balance between demand and supply at any given time. The latter is almost easy to understand. But the former is something that is missed by so many, as they tend to assume a constant demand, which is never the case. The market was confused about how Russian oil would flow after it started a war. The worst was assumed, but no one considered that the "market always finds a way." When there is an arbitrator, there will be flows.
The sanctions imposed on Russia by Europe and the U.S. ended up making tanker companies very happy as oil got rerouted on longer routes as Russian oil made its way to China and India, got refined, and made it back to the European Union. This allowed the E.U. to hold its head up high claiming righteousness, even though Russian oil really never left the market. In fact, this war has Russia and its currency coming out on top to the detriment of the E.U., which has been President Vladimir Putin's plan all along.
More importantly, this conflict has brought regions closer together as we saw China's President Xi Jinping head to Saudi Arabia last week signing about $29 billion of new energy deals bringing the two nations closer. This is quite an opportune time to announce this, especially as relations between Saudi Arabia and long-standing partner, the U.S., are getting more and more strained.
China is sweeping in as it plans to move the world's reliance on the dollar. After the meeting, China announced a new energy exchange in yuan would be used to settle these energy deals. Such historical moves do not happen overnight, but the alliances, and trade flows shift slowly over time. For now, the dollar is the strongest currency but make no mistake, the wheels of change are already set in motion.
Another factor that was used to justify the higher-for-longer oil prices was the "OPEC put," just like the "Fed put" that investors held onto desperately to justify their longs. The problem with the former is that prior to 2020, OPEC was not really the swing producer as U.S. shale played a big role in the oil market. In the post Covid world, when U.S. shale lost about 2 mbpd of oil, OPEC was in the driving seat and it had an opportunity to keep the markets tighter for longer, allowing prices to drift higher as the world opened up back up post Covid lockdowns. They were fast to cut 10 mbpd of production, but it took them 2 years to release that back onto the market. Pre-Covid oil prices were trading around $75 per barrel. Covid did not change the dynamics as there was never any shortage of oil, it just created bottlenecks in some parts of the refining cycle that caused these price rallies.
There is a case for secular oil and cyclical oil investment themes. But it is important to not mistake the two. Therein lies a trading market, as it is easy for most analysts to call it a buy. Being down 40% in one year and being right in the next two is no way to run a portfolio nor a fund. Demand has fallen short of most analysts' expectations, as the global economy is slowing, as we have seen a falloff in freight manufacturing and production. This is taking a toll on oil prices at a time when supply has been coming back from the summer levels. Commodities are all a matter of timing, a window of opportunity when flows may seem out of whack, but may not be permanent.
Now, as we approach the northern hemisphere winter heating season, heating oil inventories remain ample. In fear of running out of supplies, the EU bought all the gas possible prior to its winter, starting at multiples of where gas is trading today, before gas prices collapsed, of course.
It seems the bulls are holding onto the China reopening story as their only justification to nurse their longs. China has eased restrictions, but is it about to come back guns blazing? That remains to be seen. It had plenty of time to store up its inventories in lieu of opening. China is facing domestic issues and the government needs to be careful not to open up too quickly lest cases explode and the health care system is strained. There is no doubt that the world is already entering a global recession, the only point of contention is how long and protracted is it going to be. That shall be the deciding factor for the price of all commodities.
But first, we need to see some downgrades from the sell side that are still a good $30 per barrel away from where oil is trading today. The baton needs to be passed and eventually dropped.
