Fears of recessions and weaker-than-expected oil demand have dominated oil market sentiment for most of the first half of this year.
Yet, demand has even exceeded expectations in the spring, while the OPEC+ alliance is stepping in again to cut supply to the market. Oil prices have ignored the fundamentals so far as traders and speculators have remained focused on what sharply rising interest rates would do to economies.
Few have thought, however, what soaring interest rates – and consequently, funding costs – would do to the physical and paper market for oil apart from baking in recession fears.
Unprecedented Physical Destocking
The aggressive monetary tightening and the 500 basis points hike in Fed’s key interest rates in just one year – from a near-zero interest rate policy for over a decade since the financial crisis – is changing the structure of the oil market, analysts say.
The actual influence of soaring funding costs on the oil market is that traders are destocking and selling off physical barrels because the costs to hold crude, and the penalty for keep holding that crude if demand tumbles in a deep recession, have spiked.
“For oil refineries and trading companies, the cost of holding oil in tanks has become much more expensive,” Amrita Sen, director of research and co-founder at Energy Aspects, wrote in a post in the Financial Times this week.
History has shown that as interest rates rise, inventory drawdowns are accelerating in a backwardated market, where prices are higher for immediate delivery due to strong demand, Sen notes.
In the past, crude inventories in developed economies would fall by 10 million barrels on average year over year for each 1 percentage point hike in interest rates, the expert added.
And since March 2022, interest rates have risen by 5 percentage points.
This has led to what Goldman Sachs analysts dubbed in May “the great de-stocking,” which leaves the market much more vulnerable to shocks and to the OPEC+ moves to prop up oil prices.
Globally, commercial oil inventories are expected to sink by the end of the year to some of the lowest levels in the past decade, Energy Aspects’ Sen says.
“All this will leave the market vulnerable to shocks and unexpected Opec+ policy moves by the end of the year. Buckle up!,” she wrote.
Goldman Sachs, which has been bullish on oil all year despite the market correction that led to a $10 a barrel decline in prices so far in 2023, also sees a large and unprecedented physical and paper de-stocking in crude.
“Such unprecedented de-stocking should not be surprising. Markets have rarely seen such a sharp rise in funding costs from such a low level,” Goldman Sachs analysts wrote in a note at the end of May.
“Financially, paper commodities experienced a similar de-stock given the cost of holding positions against higher funding costs and more volatility,” Goldman analysts, including Jeffrey Currie, global head of commodities research, said.
“Barring a global recession, rock (fundamentals) should beat paper (positioning) during 2H23, creating an unwind of the significant build-up in shorts.”
The sharp increase in funding costs and the high inflation have accelerated the pace of destocking in oil, Currie told CNBC at the end of May.
“Destocking just cannot keep on going,” he said, adding that Goldman sees the fair value of crude oil at $97 a barrel at the end of this year.
Oil is currently a liability, and destocking could tighten the market so much that prices will pop up and make holding oil an asset again, Currie noted.
Demand Is Not To Blame For Falling Oil Prices
While many headlines have blamed fears of weak demand and recessions for the decline in oil prices in the first half of this year, evidence and estimates from forecasters suggest that demand has outperformed expectations.
Energy Aspects, for example, says that “oil demand has been anything but weak.” Data has shown that global oil demand has jumped by 2.5 million barrels per day (bpd) year on year, exceeding Energy Aspects’ forecast by 300,000 bpd.
According to Goldman Sachs, oil demand has surprised to the upside.
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“Despite all the concerns over a recession that many market participants view as almost certain during 2H23, it is important to emphasize that the evidence in commodities supports stronger not weaker demand,” Goldman’s analysts say.
“Beginning with oil, the IEA and other forecasters, including ourselves, have actually steadily increased oil demand growth forecasts this year.”
In its Oil Market Report for June, the IEA said that “Global oil demand continues to defy the challenging macroeconomic climate and is set to rise by 2.4 mb/d in 2023, outpacing last year’s 2.3 mb/d increase as well as earlier expectations.”
“China’s rebound continues unabated,” and its apparent demand in April jumped to an all-time high of 16.3 million bpd. India’s demand is also strong, reaching record consumption of gasoline and diesel in May, the IEA says.
Goldman Sachs analysts believe “that it is mostly supply, rather than demand, that is to blame for softer-than-expected balances.”
Once the great de-stocking is over, depleting inventories to multi-year lows, oil prices will be more vulnerable to shocks and volatility and could pop up higher.
By Tsvetana Paraskova for Oilprice.com
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