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Oil Update—June 2022

My July forecast for West Texas Intermediate (WTI) is that it will range between $100 to $120 per barrel, and this range is ten dollars lower than my June forecast.

When higher than expected inflation numbers, at over 8 percent, were announced in June, the market immediately expected the Fed would raise rates by 0.75 percent, which it did. The Fed seems committed to fighting inflation by raising rates and, thereby, increasing the odds of a recession, although the depth and length of the recession remain uncertain. Investors are fearful about the effects of a recession on oil prices, and consequently oil prices and oil equities fell in sympathy.

Many investors, however, remain bullish because worldwide inventories continue to decline. Even assuming a normal recession, many expect that the physical market for oil will continue to tighten. Eric Nuttall, from Ninepoint Partners, recently provided a worthwhile podcast and webinar with Amrita Sen from Energy Aspects. I highly encourage you to listen to the podcast and watch the webinar.

Even at WTI prices of about $110 per barrel, consumers are facing high gasoline prices because refinery crack spreads are extraordinarily high because of a lack of refining capacity. A refinery crack spread is the difference between revenue and costs for the physical outputs and inputs. A simplistic way to determine the crack spread is to use the 3:2:1 ratio of oil, gasoline, and distillate. Three barrels of WTI oil produce two barrels of gasoline and one barrel of distillate or heavy oil. Toward the end of the day on June 27, WTI was about $110 per barrel, RBOB gasoline futures were about $3.75 per gallon, and heavy oil futures, or distillate, were about $4.15 per gallon. Converting gallons to barrels and working through the math, the crack spread is about $53.10 per barrel. Crack spreads typically range between three dollars and $10 per barrel. For consumers, the gasoline prices at the pump are equivalent to about $153 (=110+53-10) WTI prices.

For more information on crack spreads, I encourage you to visit the EIA website.

As already stated, crack spreads are high because of a lack of refining capacity. Companies are loathe to build new refineries in North America because of the strenuous regulatory and environmental hurdles and because of the expected transition away from fossil fuels. Please view CNBC’s interview with Exxon’s Darren Woods. Most of the additional capacity in recent years comes from refinery creep, where existing refineries make modifications that allow for lower costs, higher throughput, or some combination.

Are there downside risks to my forecast? Yes, of course. If investors increase their expectations for a severe recession, then oil may sell off. Next, the Iran negotiations, known as the JCPOA, have shown more signs of life again. There were some meetings and calls made late last week. If a deal is struck in the near future, I am not sure how much that may influence oil. Some believe that the effects would be negligible because Iran is already exporting a lot. Other factors include a resurgence of COVID in China, a faster and harder economic slowdown, and some development with Russia that enables it to increase production.

Risks to the upside include continued oil inventory withdrawals with the physical markets tightening even further, resumption of the Chinese economy to normal activity, and Russia’s exports declining significantly.

Regarding recession concerns, the Wall Street Journal article “Consumer Sentiment at Record Low Is Another Ominous Sign for Economy” illustrates consumers’ concerns.

Consumer sentiment fell to its lowest point on record, reflecting that elevated inflation is weighing on Americans’ moods and adding to indicators that point to a slowing in the world’s largest economy.

The University of Michigan’s gauge of consumer sentiment reached a final reading of 50 in June. That was the lowest reading on record going back to 1952, and down from both an initial reading earlier in the month and May’s 58.4 reading.

New-home sales rose 10.7% in May to a seasonally adjusted annual rate of 696,000, separate data Friday from the Commerce Department showed. Economists, however, expect rising mortgage rates to weigh on sales later this year.

Similarly in Canada, as reported by the CBC in its article “Canadians are dispirited, cutting back on costs amid inflation highs: study,” consumers are also feeling the burden of higher inflation.

With inflation at a 39-year high—and banks hiking interest rates to avoid economic recession—many Canadians are said to be distressed and dispirited as they cut back to manage the rising cost of living.

A new study from the polling non-profit Angus Reid Institute shows that 45 per cent of Canadians believe they are worse off now than they were at this time last year. Inflation is now at 7.7 per cent, the highest it has been since 1983.

With grocery and gas prices skyrocketing, Canadians are trying to spend less as their personal costs go up. Almost half say they are now seeking out alternative modes of transport to avoid filling up their gas tanks.

As noted in the CBC article, some Canadians are already reducing their demand for gasoline; there is already some demand destruction taking place.

This bad news may reduce inflation because the economy has begun or will begin slowing. If inflation begins to soften, the Fed may not need to hike rates as aggressively as feared.

My own bias remains bullish on oil prices. Even though I am bullish, I will continue to watch the different factors affecting oil prices and react accordingly.

One last comment, the markets are volatile as evidenced by a recent VIX reading at about 27. That implies investors have a lot of uncertainty. I share that uncertainty because there are so many unknowns that may have a dramatic effect on the outlook for the overall economy and on the price of oil.

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