An Outlook For Oil Prices In H2 2023

When this year began, it was starting to look like the glory days for energy investors were over. Throughout most of the previous two years the sector had rapidly made up for lost time, being by far the best-performing S&P 500 sector in that timespan after a decade or so of underperforming as oil soared to well over $100. But as 2023 dawned, crude had been heading lower for a few months and energy stocks were beginning to reflect that. Still, anyone who has ever traded or invested knows that these things are usually cyclical and that, at some point, energy stocks and oil will reassert themselves. So, as the first half of the year ends, it is a logical time to take stock and assess the chances of that recovery coming in the second half of the year.

The success of energy investments in 2021 and the first part of 2022 was due to crude jumping to multi-year highs, hitting $130 a barrel in early 2022 after demand recovered quickly from the hit taken during the pandemic, just as supply reductions that resulted from WTI being below $30 a barrel for most of 2020 began to take effect. By the time this year rolled around, though, the outlook and mood were very different. The focus switched from tight supply to concerns about demand. Traders and investors were expecting interest rate hikes in the US and around the world to force a global recession and oil was beginning to reflect that expectation.

As you can see from the chart below for CL, the main WTI futures contract, however, the first six months of the year have been more about a gradual decline than a disorderly collapse. But, while the drop has been orderly, it has still been significant. Crude is now trading around sixteen percent below the level at which it opened on January 3^rd.

The Energy sector ETF, XLE has held up a bit better than crude, but is still trading more than ten percent below it start-of-year level as the first half ends…

The question for investors, of course, is whether we can expect more of the same, a steeper decline, or a bounce back in H2.

Your view on that depends largely on your view of how the US economy will perform during that time. Six months ago, there was very little disagreement on that subject amongst analysts. Recession would follow sustained rate hikes, they believed…it always had and always would. Now, though, there is a growing camp that believes that it can be avoided, that this Fed can pull off what no other has been able to do and raise rates just enough to dab on the brakes without bringing economic growth to a screeching halt. There is some evidence that that is possible, but to say it is likely is to fly in the face of both history and logic.

As I said, rate hikes have just about always caused recessions in the past, and for understandable reasons. Higher interest rates don't usually have an immediate impact on consumer or business spending, but they make a range of significant things, from mortgage and credit card payments to business loans, more expensive. Over time, that inevitably takes a toll, and growth dies. The theory this time around is that because rates had been effectively at zero for so long there was plenty of "slack" in the system, and rate increases will gradually deflate the borrowing and spending bubble without prompting a collapse to negative growth.

That sounds great in theory, but color me cynical on this one. Whether it is growth or anything else, a slow death is still a death, with the same end result. The circumstances going into this rate hike cycle may have delayed the impacts, but they cannot negate them completely. There are already signs from consumer confidence and spending data that the drunken sailor era of the recovery from the pandemic is over, and unless the Fed does a complete U-turn and starts cutting rates soon, something that Jay Powell's pride probably won't allow whatever the numbers say, a noticeable slowdown is coming in the second half of the year.

There are still things on the supply side of the equation that could offset that, of course. The Russian war in Ukraine and the internal instability that it has wrought put supply from there at risk, say the bulls, and OPEC+ has shown no reluctance to squeeze their output, despite political pressure from America and elsewhere. Then there is a Presidential administration in the US that frequently spouts anti-fossil fuel rhetoric which should, in theory, limit supply here. Look a little deeper, though, and none of those arguments holds up.

Russian oil has flowed so far, despite embargos and the like, which will surprise nobody because there will always be a market for a vital commodity sold at below-market cost, no matter what. OPEC+ clearly said that the recent output cuts were in anticipation of a slowdown in demand and that if that slowdown comes, more cuts will be needed. As a result, while oil rose initially on the news, it quickly resumed its downward path. As for the Biden factor, I always trust facts over what any politician says, and this is what has actually happened to US oil production since Joe Biden took office…

Sorry to be the bearer of bad news, but add all that up and the outlook for the second half of 2023, far from indicating a bounce back in oil and energy stocks, actually suggests that the half will start with even more weakness. That may start to turn around by the end of the year if the Fed clearly signals a reversal early in 2024, but if you are heavily invested in energy, selling into any optimism driven rallies over the next few months makes more sense than adding to holdings as markets fall.