Specious Argument

Just like last month, I am again lowering my West Texas Oil (WTI) forecast for the upcoming month by ten dollars per barrel to range between $90 to $110. While the physical market remains tight, oil may be held in check by the approaching shoulder season and recessionary fears.

A recent article on July 20 in the Wall Street Journal “Saudi Arabia Nears Its Oil Pumping Limit” (subscription required) demonstrates that the oil markets are tight and that there is a lack of surplus capacity.

Saudi Arabia has limited additional capacity to ramp up oil production, according to people familiar with its pumping ability, a constraint that would make it difficult for Riyadh to increase global supply even if it were willing to do so.

President Biden recently wrapped up a high-profile trip to Saudi Arabia, saying he expected the kingdom to help the U.S. boost global supplies. The Organization of the Petroleum Exporting Countries, with Riyadh as its de facto leader, meets early next month to determine whether to lift its current quota for production. The group has been working in recent years with a parallel group of big producers headed by Russia.

If OPEC+, as the two groups are called collectively, moves to boost production, a key question is by how much. Saudi Arabia’s slim spare capacity—the amount it can quickly ramp up on top of what it is already pumping—raises the prospect that any boost won’t be enough to appreciably lower prices.

During June and July, oil seemed to be unusually volatile, having risen to about $120 per barrel, then fallen to about $90, and it is now near $100 again. The stock market was also very volatile during this period. Although stocks had a terrific July, many are cautious or even skeptical about the months ahead. A quote from a recent July 29 Wall Street Journal article “U.S. Stocks Rise, Giving S&P 500 Best Month Since 2020” (subscription required) shows the gains for the S&P 500 and Nasdaq and concerns about the market going forward.

The S&P 500 gained 9.1% in July, while the Dow Jones Industrial Average rose 6.7%, the strongest monthly showing for each index since November 2020. The tech-heavy Nasdaq Composite climbed 12% for its best month since April 2020.

Investors have taken comfort in recent days from the idea that slowing economic growth might encourage the Fed to raise rates at a slower clip. They also have been encouraged by positive signals during earnings season, as expectations for quarterly profit growth rose over the past month.

But money managers and strategists are also debating whether stocks can hold on to the recent gains in the face of continued monetary tightening and worrisome signals about the economy. Many are skeptical.

Because of the strong cross currents of tight physical oil markets and recessionary fears, along with a war in Europe, it is hard to have much confidence in any forecast. Everyone is watching to see if strong recession indicators appear and how that might affect oil.

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.

In last month’s update, I was unable to provide a forecast because China continued to battle COVID, Joint Comprehensive Plan of Action (JCPOA) negotiations were still unresolved, the market belief that the Fed will increase rates aggressively, Europe was considering sanctioning Russian oil, and the war in Ukraine continuing to rage. While all these factors continue to be true in varying degrees, the market appears to be acclimatizing itself to this new, harsh environment.

My forecast is that West Texas Intermediate (WTI) oil price will range between $110 to $130 per barrel during the month of June. With inflation in the high single digits in Europe and the US, central banks are determined to raise rates. During the past month, stocks have been volatile and were down significantly before rebounding in late May. Even as I write this post, the VIX is hovering around 26 percent, which is high. If the economy continues to struggle with interest rate increases, oil prices may fall in sympathy with other financial assets. On the other hand, as Europe continues to reduce its dependence on Russian oil and gas, oil prices may well go higher. On balance, I am more concerned about oil prices surpassing the high end of my range than the lower end because I expect the oil market to continue to tighten.

Some might be inclined to think that a $20 price range forecast is excessive. When oil prices were in the $60s, I gave a $10 price range. Now that oil prices have roughly doubled and in a continuing uncertain geopolitical and economic environment, assuming no major events that might cause an oil price shock in either direction, I am comfortable with a $20 price range. Also, the U.S. Energy Information Administration’s “Short-Term Energy Outlook” released on May 10 similarly used a reasonably wide range.

EIA May 2022 Short-Term Energy Outlook Oil Price Confidence Intervals

On the topic of inflation, in a May 30 op-ed article (subscription required) in the Wall Street Journal, President Biden stated the following:

First, the Federal Reserve has a primary responsibility to control inflation. My predecessor demeaned the Fed, and past presidents have sought to influence its decisions inappropriately during periods of elevated inflation. I won’t do this. I have appointed highly qualified people from both parties to lead that institution. I agree with their assessment that fighting inflation is our top economic challenge right now.

Second, we need to take every practical step to make things more affordable for families during this moment of economic uncertainty—and to boost the productive capacity of our economy over time. The price at the pump is elevated in large part because Russian oil, gas and refining capacity are off the market. We can’t let up on our global effort to punish Mr. Putin for what he’s done, and we must mitigate these effects for American consumers. That is why I led the largest release from global oil reserves in history. Congress could help right away by passing clean energy tax credits and investments that I have proposed. A dozen CEOs of America’s largest utility companies told me earlier this year that my plan would reduce the average family’s annual utility bills by $500 and accelerate our transition from energy produced by autocrats.

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Third, we need to keep reducing the federal deficit, which will help ease price pressures. Last week the nonpartisan Congressional Budget Office projected that the deficit will fall by $1.7 trillion this year—the largest reduction in history. That will leave the deficit as a share of the economy lower than prepandemic levels and lower than CBO projected for this year before the American Rescue Plan passed. This deficit progress wasn’t preordained. In addition to winding down emergency programs responsibly, about half the reduction is driven by an increase in revenue—as my economic policies powered a rapid recovery.

Regardless of one’s political leaning, we can all feel the effects of inflation. How successful politicians and central banks will be in fighting inflation without causing a recession remains to be seen.

As the West continues to take action against Russia, I expect oil and gas markets to continue to tighten. As mentioned in the May 31 article (subscription required) “EU’s Ban on Russian Oil Adds Stress to Region’s Economies” in the Wall Street Journal, Europe is taking active steps to reduce its dependence on Russian oil.

The European Union is set to impose its toughest sanctions yet on Russia, banning imports of its oil and blocking insurers from covering its cargoes of crude, officials and diplomats say, as the West seeks to deprive Moscow of cash it needs to fund the war on Ukraine and keep its economy functioning.

The sanctions, which are expected to be completed in the coming days, are harsher than expected. The ban on insurers will cover tankers carrying Russian oil anywhere in the world. These sanctions could undercut Russia’s efforts to sell its oil in Asia. European companies insure most of the world’s oil trade.

The embargo is a high-risk strategy for the EU, forcing the bloc to break its dependency on cheap Russian energy. It is likely to fuel inflation already running at the highest pace in decades on both sides of the Atlantic.

Just as I was drafting this article, the Wall Street Journal reported (subscription required) in an article titled “OPEC Weighs Suspending Russia From Oil-Production Deal” that some OPEC members are exploring Russia’s participation in an oil-production deal.

Some OPEC members are exploring the idea of suspending Russia’s participation in an oil-production deal as Western sanctions and a partial European ban begin to undercut Moscow’s ability to pump more, OPEC delegates said.

Exempting Russia from its oil-production targets could potentially pave the way for Saudi Arabia, the United Arab Emirates and other producers in the Organization of the Petroleum Exporting Countries to pump significantly more crude, something that the U.S. and European nations have pressed them to do as the invasion of Ukraine sent oil prices soaring above $100 a barrel.

Russia, one of the world’s three largest oil producers, agreed with OPEC and nine non-OPEC nations last year to pump more incrementally more crude each month, but its output is now expected to fall by about 8% this year. It couldn’t be determined whether Russia would agree to an exemption from the deal’s production targets.

As the news broke, oil fell from about $117.50 per barrel to about $114 and then rebounded to about $115. My guess, however, is that OPEC will try to take steps to prevent oil prices from suddenly spiking higher but will not attempt to drive prices lower. This development bears watching closely.

Helima Croft retweeted her interview with CNBC:

Oil taking a leg lower this afternoon after reports that OPEC may suspend Russia from its oil production deal.

RBC's @CroftHelima gives us her take on the headline pic.twitter.com/r08XS5yh8v

— CNBC's Closing Bell (@CNBCClosingBell) May 31, 2022

After the initial headline shock from the Wall Street Journal, I expect oil prices to recover.

As stated, my forecasted range of $110 to $130 per barrel is based on the current environment continuing without any major shocks. If the economy worsens faster and more severely than expected or the war takes a sudden turn, then, of course, all bets are off.

Switching topics, I just finished reading a book (Amazon affiliate link) Oil Leaders: An Insider’s Account of Four Decades of Saudi Arabia and OPEC’s Global Energy Policy (Center on Global Energy Policy Series) by Ibrahim AlMuhanna. For those who believe that the oil markets are perfectly rationale and predictable, this book debunks that theory. AlMuhanna mentions that there are important players who can influence the oil markets:

In my opinion, six important players are able to influence market direction, one way or another:

1. International business media, particularly specialized energy publications. It is not only what is reported but also the way events are reported, such as the people who are quoted, the news headlines, and news alerts.
2. Oil experts and analysts, whether independent or part of a large organization. IHS Markit and PIRA Energy Group, for example, interpret events and information and predict the direction of the oil market and oil prices, which influences the futures market.
3. International energy organizations, especially the International Energy Agency (IEA) and OPEC. These information warehouses publish monthly reports about the international oil market that are widely quoted, and their estimates on supply and demand and commercial stocks influence the oil market and its behavior.
4. Hedge funds and commercial banks. These players take positions in the oil futures market (long and short), expecting high or low oil prices. Their positions are based on their own in-house information and analysis as well as information from public and private oil officials and experts.
5. Government officials from major oil-producing and oil-consuming countries. Whether speaking publicly or privately, what they say can, and does, have a strong influence on the direction of oil prices, especially when inside information or new policy trends are discussed.
6. Major oil companies (national or international), including oil trading companies. Most of these companies have extensive internal analyses but do not like to discuss the oil market publicly. They don’t want to be quoted, nor do they typically reveal their information, expectations, and position in the market. Nevertheless, when their information is leaked or given to a limited number of people in a confidential way, they can influence the market and its direction.¹

If you are interested in the oil markets, I recommend Oil Leaders.

This month’s update is nearly identical to that from last month in that I am unable to provide a forecast with any confidence.

China continues to battle COVID, Joint Comprehensive Plan of Action (JCPOA) negotiations still are unresolved, the market believes that the Fed will increase rates aggressively, Europe is considering sanctioning Russian oil, and the war in Ukraine continues to rage. These are just some of the key factors affecting oil prices. I find it impossible to provide a reasonable forecast range for the next month. As I stated last month, if I were to supply a range, it would be absurdly wide, which would render it useless. My expectation is that oil prices will continue to stay volatile and at elevated levels.

For those of you wanting to watch how the market perceives future rate increases, the CME Group provides a useful FedWatch Tool.

Europe has been wrestling with sanctioning Russian oil. It seems that progress is being made as evidenced by the April 28 Wall Street Journal article “Germany Drops Opposition to Embargo on Russian Oil” (subscription required).

BERLIN—Germany is now ready to stop buying Russian oil, clearing the way for a European Union ban on crude imports from Russia, government officials said.

Berlin had been one of the main opponents of sanctioning the EU’s oil-and-gas trade with Moscow.

However on Wednesday, German representatives to EU institutions lifted the country’s objection to a full Russian oil embargo provided Berlin was given sufficient time to secure alternative supplies, two officials said.

John Kemp wrote the Reuters article “Oil prices paralysed between Russia sanctions and China lockdowns: Kemp” where he stated:

The combined net long position of 553 million barrels is in only the 39th percentile for all weeks since 2013 while the ratio of long to short positions at 4.59:1 is somewhat higher in the 59th percentile.

Fund managers remain moderately bullish about the outlook for prices but extreme volatility has made it risky and expensive to maintain existing positions or initiate new ones.

Reflecting higher margin calls, the total number of open futures positions for all categories of trader is the lowest for seven years, although it has stabilised in the last fortnight after falling sharply since mid-February.

His statements that the number of open contracts is extremely low implies that oil prices may whip around on lower volumes than are typical.

As stated, I believe oil prices will stay volatile at elevated levels. If pressed further, I am inclined to think West Texas Oil prices will climb, in the months ahead, above the current price of about $105 per barrel.