Energy market a “crapshoot”: Supply-led bulls face off against demand-deficit bears

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In an earlier piece entitled, “Winter is coming: European buyers shifting from natural gas to crude oil”, we focused on the view of Amrita Sen, an internationally renowned crude oil expert, who made the case for a return to $120 per barrel. 

Given the major shortages in the market, and with European economies pledging to reduce Russian gas imports by two-thirds within a year, the EU may be forced to accelerate the rationing of energy resources, identify efficiency savings and invest in alternative infrastructure, fuelling the bull case.

However, with a likely recession fast approaching, not all market analysts share this view.

Most notably, Ed Morse, Citi’s Global Head of Commodities Research, believes that bearish factors are much more prevalent than most acknowledge. His thesis focuses on the severity of weakness in global demand.

Morse does not expect ongoing supply disruptions to automatically dominate price action, pointing out that there are “very big lumpy uncertainties” in the market, and the direction that oil prices take is “a crapshoot at the moment.”

Morse calls out necessarily bullish projections as “wishful thinking.”

His view that the “probability is higher for lower prices than higher prices right now” is based on the following:

Efficiency of capital employed in oil and energy projects is high, meaning that every dollar invested will add plenty to the global supply.Crucially, demand in the US and Europe is “flirting with a 10-year low”, and with a 50-50 chance of a global recession, this will only fall further. Gasoline prices in the US are down for the 11th week in a row, falling to pre-Russia-Ukraine levels.Due to the severity of lockdowns and China’s own economic difficulties, demand from the world’s most populous country has not materialized. Moreover, Chinese manufacturing activity contracted for the second straight month, settling at 49.4.Although production from Iraq may be threatened, Morse believes that Iranian supply could come online ensuring sufficient global supplies.

He concedes that there are supply concerns that could push the price higher, but doesn’t “see where the demand is coming from.” This scenario in his view is especially true for the next month.

With eurozone inflation rising to 9.1% in August, the ECB is expected to hike rates sizeably this month, leading to lower demand and potentially an out recession.

Interestingly, Morse states that financial players are being driven out of the market by the sheer degree of volatility that follows each announcement and fresh news snippet.

As a result, he expects that the market direction is being charted purely by algorithmic traders and technical analysis.

The bullish case

Jeff Currie, Global Head of Commodities Research for Goldman Sachs, as well as Helima Croft, Head of Global Commodity Strategy at RBC Capital Markets, believe that there is significant upside potential to be had. In fact, Currie described the SPR (Strategic Petroleum Reserves) -fuelled lows as “a buying opportunity.”

Although European leaders especially in Germany have highlighted that natural gas inventories are strong at about 80%, Currie points out that “inventories supply some of the relief but not all the relief.”

In other words, to maintain energy security, a continuous flow of robust sources must be ensured, which is currently not the case.

 With Russia being shoved out of the market, European governments may find themselves in an increasingly precarious position, especially in light of the coming winter.     

Norway, which has now displaced Russia as the largest supplier of oil and gas to Europe, as well as supplies from Algeria and the United States are playing a role in filling the gap left by Russia.

However, according to Currie, these volumes will not be sufficient, and at high price points, he expects substitution away from natural gas towards oil and oil-based products such as diesel and jet fuel.

In fact, he believes that demand will very likely outstrip supply unless the winter is especially mild which is “a big assumption.”

Echoing this sentiment was Shell CEO Ben van Beurden, who warned, “I do not think this crisis is going to be limited to just one winter… It may well be that we have a number of winters where we have to somehow find solutions…”

Ongoing energy deficits and hydropower shortages in China will only place more pressure on the global market energy market, especially if China begins to recover economically.

Following a fresh outbreak of new covid cases, China imposed neighbourhood lockdowns in several cities, dragging down energy demand.

Currie’s thesis on rising prices draws on the following:

Seasonal demand peaks in Q4.The additional SPR flows from the US will end in October 2022.Globally low inventories imply that markets will have no cushion to fall back on.A lack of spare capacity except for in Saudi Arabia and the UAE.Amount of investment is low given the rig counts in the United States, so supply will always be limited.

Since the demand for oil and energy products is inelastic, Currie believes that this market offers excellent late-cycle stage opportunities.

Most intriguingly, he adds that in the past, when macro markets forecast a recession (such as in the case of the inverted yield curve this month) which did not immediately materialize, oil has consistently rallied 80-100%.

He notes that occurred in 1994, the previous occasion that the Fed raised rates by 75 bps, as well as 2006 when the yield curve inverted but recession only hit the following year.

Currie’s bullish projections are available in the table below:

Source: CNBC

A report by Bartrum, Pope and Tetlow of the Institute of Government concurs that projections for energy prices are likely to rise, may be higher next year, and stay elevated for longer.

Although Iraqi oil supplies have not seen major disruption yet, the resignation of cleric Muqtada al-Sadr from politics has led to social havoc.

Fernando Ferreira, a director at Rapidan Energy Group called the country’s current political environment “extraordinarily toxic” and capable of interfering with global oil supplies given the country accounts for 3.5% of global demand.

Timothy France, a senior oil market analyst at Refinitiv also noted that supply disruptions could be significant, with Ferreira projecting a potential increase of “$5-10” if output slows.

Croft confirmed that protesters were active in the vicinity of facilities that were responsible for approximately one million barrels of oil production per day. She noted that although no operations have been disrupted yet if protesters were to enter the facilities this could be costly given the tightness of the market.

Violence in Tripoli led to a temporary crash in Libyan oil output and the closure of vital ports, while fears that this may kick-start civil war once again took hold.

The state-led oil producer, National Oil Corp, has been central to the existing power struggle, although it has “returned to pumping near maximum levels“ for now.

Electricity markets

Ever since the Ukraine-Russian war, the price of electricity has been extremely volatile.  Gas prices have surged 10x rise throughout continental Europe since last year.

Although regulatory bodies have suggested structural reforms to be instituted, Austrian Chancellor Karl Nehammer backed an EU-wide cap  to “finally stop the madness that is taking place in energy markets.”

Bloomberg estimated that Europe’s benchmark power price is trading at the “equivalent of $1,101 a barrel crude oil.”

Given that electricity prices are set in the financial markets, and draw their value from the most expensive source of power generation, the market does not show any signs of easing in the near term.

Croft added that the fundamentals of sources and price determination of European electricity are diverging further, and the use of price caps to manage this seems to be gaining popularity.

European support for utilities may be required desperately as corporations continue to suffer from high costs but uniform remuneration. For example, Uniper in Germany is being bailed out by the government which will also be taking a 30% equity share, while France is taking full control of EDF.

Croft notes the growing importance of pragmatic sources of energy, with European oil experts beginning to support the need for alternative sources including nuclear power to ensure energy security.

For instance, Switzerland is scrambling to keep 5 nuclear plants operational that were scheduled to be closed after the Fukushima disaster. Germany too has been seeing growing calls to reverse its earlier decision and instead maintain its nuclear plants.

To support electricity consumption, European countries have pledged a whopping 280 billion euros towards lowering energy bills for households and businesses via natural gas tax cuts and subsidies.

Tsvetana Paraskova, oil and energy writer reports that these measures could significantly backfire by encouraging demand and leading to more inflation.

Joanna Mackowiak-Pandera, president of Forum Energii, added “We haven’t reached the bottom of the crisis yet” implying that a price rise is most certainly on the cards.

Bassam Fattouh and Andreas Economou of The Oxford Institute for Energy Studies wrote that “Under a perfect storm of negative drivers”, oil prices could settle in the $70 range.

As per their model, this makes the unlikely assumption that Russian supplies are fully restored. In the absence of this condition, they estimate that in a bearish scenario oil prices could settle between $75/b and $85/b.

Given the current uncertainty in the energy market in Europe and the lack of clarity on what factors drive global prices, it appears that bullish investors anticipate year-end oil prices to be in the range of $120 – $130, while bears expect oil demand to weaken driving prices into the 70s.

At the time of writing, WTI was trading at $88.8, while Brent was at $96.5.

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