Oil prices have been on a wild ride. Volatility has recently increased as jawboning is creating whipsaw price action. In the week ahead of the U.S. Thanksgiving Holiday, WTI oil prices tumbled below $75 (chart below) per barrel as OPEC announced that the cartel was considering an output increase ahead of the December 4, 2022, OPEC+ meeting. The group’s move comes just before the European Union is poised to impose an embargo on Russian oil. The action by the EU would essentially take petroleum from Russia off the market. Additionally, one of the largest consumers of petroleum continues to experience lockdowns or restrictions as the capital, Beijing, warned on Monday that the city is facing more severe COVID-19 issues and has shuttered businesses and schools. The city’s infections have ticked higher in Beijing than it has nationally in China.
What is Going on in China
China continues to battle COVID-19 using its zero-COVID policy. The strategy has created several fits and starts as the country tries to emerge from lockdowns. While the Chinese have used COVID-19 vaccines, there are questions about the length of the protection provided by these products. Data has shown that the immunity from doses wanes rapidly, and the protection it offers to older people is limited. Additionally, China has a zero-COVID policy. Instead of allowing the infection to propagate amongst people who have been vaccinated, the government calls for lockdowns. This strategy has crushed the Chinese economy and has limited petroleum demand. On Monday November 22, China reported 22,000 fresh COVID cases. China consumes approximately 13 million barrels of crude oil per day during non-COVID times. The volatility in their consumption has made crude oil investing volatile.
The Supply Side is Also in Flux
Chinese demand has played a considerable role in the price of WTI crude oil. As the Chinese people move in and out of lockdowns, prices have fluctuated. The supply side of the equation has also been in flux as Russia and Ukraine continue to battle in the Black Sea region. Russian oil output is poised to decline by 1.4 million barrels per day in 2023 due to an EU ban. The goal of the EU is to reduce revenue from oil sales to Russia, which will create further uncertainty for oil markets and add pressure to prices ahead of the Winter.
Additionally, beginning on February 5, 2023, the EU will ban products such as diesel fuel and gasoline. There is also a G7 plan that will allow shipping services for Russian oil but only at capped prices. The price restrictions will reduce the revenues sent to Russia in return for their oil. The move means that the EU will need to replace approximately 1 million barrels of crude oil daily and 1.1 million barrels of products daily. The pressure on diesel prices that are non-Russian origin will become fierce. One of the benefits of the weak Chinese economy is that there will be less competition from China to purchase diesel fuel and crude oil from non-Russian suppliers.
There had been rumors that delegates were considering an increase in OPEC+ production ahead of their meeting on December 4, 2022. On Monday, November 21, the Wall Street Journal reported that Saudi Energy Minister Prince Abdulaziz bin Salman had denied these reports. An output increase would be a sharp reversal following last month’s decision by OPEC+ to reduce production by 2 million barrels a day. Since that decision, prices have only moved lower (see chart). The initial concern from OPEC+ is that a slowing of global growth would erode crude oil demand and, therefore, less oil needed.
The Biden Administration was extremely disappointed with OPEC+ when it announced the cuts in OPEC+ crude oil ahead of the mid-term elections. The administration has continued to release oil from its strategic petroleum reserve to stave off higher prices. It appears that discussions of an oil output increase started after the Bide Administration told a Federal Court that Saudi Crown Prince Mohammed bin Salman would receive immunity from a U.S. Federal lawsuit related to the killing of Saudi journalist Jamal Khashoggi. The exemption was someone of a quid pro quo. The move is geared to fend off higher oil prices ahead of the Winter. Oil demand is expected to increase by 1.69 million barrels daily in Q1 compared to the first quarter’s average. Any oil production increases to replace Russian oil would set the stage for a battle between two oil heavyweights. OPEC+ members of Iraq and the United Arab Emirates want to pump more oil to generate more revenues when prices are elevated.
Ahead of the Winter Supply of Distillates has Dwindled
There are concerns around the globe that a frosty winter could lift prices. In the United States, the Energy Information Administration forecasts that heating oil prices will be higher due to colder forecasted temperatures this coming Winter. They estimate that expenditures will increase by 45% compared with last Winter. A 45% increase will not sit well with the American consumer, so the Biden Administration is attempting to head off this issue by having OPEC+ produce more oil.
One of the most significant issues facing the U.S. and the rest of the world is the lack of refining capacity. Refining petroleum is turning crude oil into used products, such as gasoline, diesel fuel, jet fuel, and heating oil. While a minor refinery was put into production this year, the last major refinery that was put into production with significant downstream capacity in the United States was the Marathon facility in Garyville, Louisiana, built-in 1977. The lack of refining capacity has made a tough situation worse. Refiners in the United States run their operations near 93% of total capacity. Despite the efforts, total distillates stocks (which include diesel fuel and heating oil) are 15% below the 5-year average range for this time of year, just ahead of the North American winter season. Unfortunately, more crude oil will not increase the capacity; it will only make more crude oil available. A conclusion that might be reached is that adding more crude oil to the mix is geared toward jawboning the prices of oil and products, despite the lack of refining capacity to drive down the price of crude oil products such as diesel fuel.
Higher Rates Weigh on Prices
Another issue that is weighing on prices is higher interest rates. Central banks across the globe have been increasing interest rates to stave off inflation. Their efforts have reduced demand and made borrowing costs higher. Additionally, the Federal Reserve has moved quicker than most central banks, buoying the U.S. dollar to multi-year highs. Since most of the crude oil globally is priced in U.S. dollars, a stronger dollar will lead to a lower price for crude oil. The Fed has raised interest rates by nearly 4% in 2022, putting significant pressure on crude oil prices. The efforts by the U.S. central bank have reduced energy inflation which could be one of their goals.
The lack of demand has put pressure on prices forcing WTI crude oil down from above $120 per barrel in June 2022 to below $75 per barrel. Prices held trend line support near $80 and await more clarity on whether OPEC+ will increase production just a month after reducing output by 2 million barrels per day. Crude oil prices have dropped 33% since rising above $120 per barrel in June.
The Bottom Line
The upshot is that oil prices have declined but have been volatile. Supply and demand dynamics have created a situation where the market is on edge. OPEC+ could be poised to increase output the month after announcing that it was reducing output. This move by OPEC+ comes as the Biden Administration is making gestures to push OPEC+ into pumping more oil. Simultaneously, the European Union is poised to ban Russian crude oil in early December, which would make oils made outside of Russia dearer. In February 2023, the EU will exclude Russian products such as gasoline and diesel fuel. The ban comes as distillate product is down substantially. In the United States, the Energy Information Administration expects the price of heating oil to increase expenditures by 45% year over year. The zero Covid policy in China also creates volatility on the demand side of the ledger. If China comes back into the fold and Russian oil is taken off the market, prices will quickly turn higher, and volatility will continue to perpetuate.