Every day that goes by, Brent oil's price falls a little more and is lagging other assets. Today it is trading below $84 a barrel despite renewed optimism in the markets about China being back after ditching its zero-Covid strategy and reopening its economy.
After China was shut for about two and a half years, it was the obvious call to think oil prices would move higher as Chinese citizens were allowed to move around again and an additional 1.5 million barrels per day of demand was expected to hit the market. What's more, Chinese indexes rallied 30%, taking emerging markets higher as the dollar fell toward the end of the year across the board. All indexes that lagged in 2022 have found new hope in 2023 as even the chronically weak European market is up 30% despite the euro rallying more than 10% against the dollar.
However, commodity markets are not as linear as that as they are not just about China despite that nation accounting for more than 30% of global consumption in some markets. Demand and supply are dynamic variables that need to be monitored to see inventory levels constantly.
Last year was all about supply tightness given the post-Covid demand surge aided by the Russian invasion of Ukraine that kept the supply side very tight. But economic theory still works and demand catches up with supply eventually, and this is what is taking the market by surprise. Demand is not as strong and is staying lower for longer just in time for the supply side to catch up.
Global product inventories had been low all throughout 2022, but we know that pricing is about the rate of change and not the absolute level itself. Inventories are now picking up as demand stays weak, which is alleviating some of the stress in the markets as curves normalize and physical markets are a lot less tight. This causes the curve to move to a small contango, which means the future price of oil is higher than the front month, incentivizing producers to store oil for the right price.
If the market was seriously tight, we would be in severe backwardation. However, that level of backwardation has eased, which suggests the physical market is not as tight as everyone thinks it is. Speculative money chases a theme first and asks questions later.
So far, China's reopening has not resulted in additional barrels as China has been smart enough to use its onshore inventories. More importantly, Russian barrels that were deemed lost have stayed flat to slightly higher; Russia is still pumping close to 10 million barrels per day and its oil is finding its way to India, the biggest importer of Russian oil, and China. This requires less of a pull for OPEC barrels, and so it is about global rebalancing.
Most investors expect China to save the world -- that is, if China is growing, the entire world will grow as well. But it is not that simple, as the end-user markets are the European Union and United States as well. If those economies are slowing, which they are drastically, then the exports out of China will suffer, too, or at least they will import less.
The Fed never before has raised rates by 450 basis points in one year. The rate of change in rates is drastic at a time when global debt levels have not been higher since the end of World War II. It may be wishful thinking to assume the Fed magically has avoided the nastiest recession in history and managed to get inflation under control with unemployment at record lows without any hiccups. You can be as spiritual as you want, but even that is a massive leap of faith. Over the past decade, the global economy hardly managed growth of 1% to 2% with rates at zero, yet now the market assumes a soft landing and global growth rebound with rates closer to 5%. It is time to get the rabbit's foot out.
