-The conflict between Russia and Ukraine only added to global supply concerns sending the per barrel price of oil to $123 on March 8, 2022 , making the increase seven-fold from only two years prior. After retreating due to recession fears, more recently, as OPEC+ production cut spooked the markets, oil saw a 16% in price hitting $92.64 before dropping by 9% to $85 on October 21st as recession and lower demand fears starting dominating the sentiment.
–There are four factors that drive global oil prices: the supply provided by OPEC & non-OPEC countries, demand from OECD[1] and non-OECD countries, financial markets and spot prices and lastly inventory of oil. OPEC is a significant player in the oil market. 13 OPEC countries produced 36% of the world’s crude oil as at beginning of 2020.
–Equally important to global prices, OPEC’s oil exports represent about 60% of the total petroleum traded internationally. Therefore OPEC can have a significant influence on oil prices by setting production targets for its members as it includes countries with some of the world’s largest oil reserves
–Oil prices are affected by events that have the potential to disrupt the flow of oil and its end products, including geopolitical and weather-related developments. These types of events may lead to actual disruptions or create uncertainty about future supply or demand, which can lead to higher volatility in prices.
–OPEC+’s September production estimates suggest that the actual production is already below the “target” levels by about 3.6 million barrels a day so the 2 million barrel cut would have only a negligible effect. Therefore, of the 20+ countries in OPEC+ only eight countries are expected to reduce their output and bulk of this is to be shared amongst three — Saudi Arabia, the United Arab Emirates and Kuwait In response to Ukraine-Russia conflict potential disruption to supply lines, in March 2022 US President Joe Biden unveiled his plan to discharge 180 million barrels in total from Strategic Petroleum Reserves to buffer the surge in prices for consumers. To date, about 165 million barrels have been delivered or put under contract since the program was put into effect. As of October 4th, the U.S. had 405.1 million barrels of oil in its Strategic Petroleum Reserves.
–The US uses these reserves to increase supply when necessary, such as when supply lines are interrupted after a natural disaster. US noted that they are prepared to conduct additional sales this winter if conditions require it, although the oil released from the reserves is expected to provide only a limited buffer given the world daily oil consumption was estimated at 94.4 million barrels at the end of 2021.
–In their Winter Fuels Outlook, the US Energy Information Agency, EIA, forecasts that average household expenditures for home heating fuels will increase this winter because of both higher expected fuel costs and higher energy consumption due to expected colder temperatures.
-Compared with last winter, in nominal terms, they forecast expenditures in the US for homes heat with natural gas will rise by 28%, heating oil by 27%, electricity by 10%, and propane 5% from 2022 October – 2023 March.
-Other winners of higher oil prices are expected to be the net oil exporters such as Saudi Arabia, Russia, Iraq, United Arab Emirates and Norway amongst others and net importers such as China and United States could be on the losing end. There is however a caveat – being a net exporter may not be sufficient to win in the complex game of petroleum products.
–Countries like Canada who produce more than they can consume but still import oil and byproducts due to various issues could be hurt seriously not only because of increased oil prices but also because of their less valuable currency against the US dollar given oil is priced in US dollars
–Importing countries like Turkey who have currencies depreciating against the US dollar and have small or no oil production to offset these losses may be the losers The winners of oil price increase will be those countries who can maintain or strengthen their economies and currencies during this period and who can match their internal oil demand with their own production and are able to be less reliant on oil going forward.
Lately the global financial markets have been rattled by global inflation on the rise. Headlines are captured by energy prices, particularly price of crude oil, black gold. The reason is clear – oil has seen some serious swings particularly over the last couple years.
The below price graph of New York based NYMEX West Texas Intermediate (WTI) first month futures contract, the benchmark for global crude oil, tells the story beautifully. Oil first bottomed out at $17 per barrel on April 24, 2020 after OPEC+[2] countries, particularly Saudi Arabia and Russia couldn’t agree on whether to cut their production. This sent the oil price tumbling further down while the financial markets were already dealing with their own troubles – markets went into a vicious drawdown due to Covid pandemic shutting down businesses and life across the globe. As the agreement was reached to cut production, in just a month oil doubled in price to $34 before hitting $48 by the end of the year and $75 by the end of 2021 due to increased global demand and supply chain issues. This was four-fold of its bottom in April 2020. The conflict between Russia and Ukraine only added to global supply concerns sending the per barrel price of oil to $123 on March 8, 2022 , making the increase seven-fold from only two years prior. After retreating due to recession fears, more recently, as OPEC+ production cut spooked the markets, oil saw a 16% in price hitting $92.64 before dropping by 9% to $85 on October 21st as recession and lower demand fears starting dominating the sentiment.
Crude Oil Has Seen Some Wild Swings Lately
Source: Bloomberg Markets
Given its broad use and impact on global economy combined with significant price moves, it is not surprising that forecasting price of oil has been top of mind. After all, it is impossible to talk about supply chain disruptions, inflation or global growth without having a deeper understanding of what drives crude oil prices and where it is headed. In this month’s issue we have devoted this section to analyzing oil, its uses, drivers of its price, its short-term outlook and how it is expected to impact global economy in aggregate.
JOURNEY OF CRUDE OIL BASICS
Let’s start with a brief description of crude oil and what petroleum products are. Once crude oil is extracted from the ground, it is sent to a refinery where petroleum “byproducts” are created from oil. Byproducts include gasoline, distillates such as diesel fuel and heating oil, jet fuel, petrochemical feedstocks, waxes, lubricating oils, and asphalt. Most refineries focus on producing transportation fuels. More than a dozen other petroleum products are also produced in refineries including liquids the petrochemical industry uses to make a variety of chemicals and plastics [3].
This does not mean each refinery produces the same set or amount of byproducts; what each refinery produces depends on its type, the production cost of each byproducts and what is in demand at that point in time. The individual by-product produced could change from month to month as well as annually.
Crude oil is quite versatile in terms of its byproducts. Diesel is used by diesel engines in various kinds of vehicles including cars, buses, boats and trains. Diesel fuel is also used in diesel-engine generators to generate electricity, such as in remote villages in Alaska, among other locations around the world. Many industrial facilities, large buildings, institutional facilities, hospitals, and electric utilities have diesel generators for backup and emergency power supply. Heating Oil is sold mainly for use in boilers and furnaces (for space heating) and in water heaters.
[2] The Organization of the Petroleum Exporting Countries (OPEC) is a permanent intergovernmental organization of 13 oil-exporting developing nations that coordinates and unifies the petroleum policies of its Member Countries A number of non-OPEC member countries also participate in the organisation’s initiatives such as voluntary supply cuts in order to further bind policy objectives between OPEC and non-OPEC members. This loose grouping of countries, known as OPEC+ includes Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, the Philippines, Russia, South Sudan and Sudan. www.opec.org
[3] Source: US Energy Information Administration www.eia.gov
WHAT AFFECTS PRICE OF OIL?
There are four factors that drive global oil prices: the supply provided by OPEC & non-OPEC countries, demand from OECD[4] and non-OECD countries, financial markets and spot prices and lastly inventory of oil.
OPEC History & OPEC Supply
The OPEC was established in Baghdad, Iraq, with the signing of an agreement in September 1960 by five founding countries Islamic Republic of Iran, Iraq, Kuwait, Saudi Arabia, Venezuela and eight other countries who joined afterwards Libya (1962), the United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Gabon (1975), Angola (2007), Equatorial Guinea (2017) and Congo (2018). OPEC was organized at a time when most of the oil produced by OPEC countries was controlled by a group of multinational oil companies called “Seven Sisters”. The purpose of the alliance was to regulate the supply and therefore the price of oil which they didn’t have control over individually. The 1973 OPEC oil embargo was the first time OPEC flexed its muscles. It cut off oil to the United States on the back of a conflict. By the end of the embargo in March 1974 the price of oil had risen four times from $3 to nearly $12 per barrel and contributed to an oil shock and recession in the US and some of the oil importing countries at the time. It was also after this embargo that US created its Strategic Petroleum Reserves to reduce its reliance on oil imports[5].
OPEC IS A SIGNIFICANT PLAYER IN THE OIL MARKET
OPEC is a significant player in the oil market. 13 OPEC countries produced 36% of the world’s crude oil as at beginning of 2020. Equally important to global prices, OPEC’s oil exports represent about 60% of the total petroleum traded internationally. Therefore OPEC can have a significant influence on oil prices by setting production targets for its members as it includes countries with some of the world’s largest oil reserves.
When global market demand is higher than the oil supply provided by non-OPEC members, OPEC has the ability to make up that difference. This difference is referred to as call on OPEC because OPEC members maintain the world’s largest spare crude oil production capacity. Whether OPEC chooses to utilize it or not is generally an indication regarding how tight the global supply is as well as how OPEC is aiming to influence the price of oil. Saudi Arabia, the largest oil producer within OPEC and the world’s largest oil exporter, historically has had the greatest spare capacity of more than 1.5 – 2 million barrels per day to be used for market management.
OPEC’s spare capacity has been used as a key indicator to gauge the world’s ability to meet supply reductions during periods of economic and geopolitical crisis, particularly geopolitical events within and between OPEC countries which have resulted in reductions in oil production historically. Why is this important? Because lower the spare capacity, higher is the sensitivity to an upward pressure in oil prices. For example, between 2003 and 2008, the spare capacity of OPEC was near or below 2 million barrels per day (or less than 3 percent of global supply), which provided very little cushion for fluctuations in supply during rapidly rising demand[6].
NON-OPEC Supply
Oil production from countries outside OPEC represented 64% of world oil production in 2020. Main locations for non-OPEC production include North America, regions of the former Soviet Union and the North Sea. Producers operating in non-OPEC countries tend to be price takers. In other words, they respond to market prices as opposed to influencing the oil prices by managing production like OPEC countries. Hence, producers in non-OPEC countries tend to produce at or near full capacity and so have little spare capacity. Other things being equal, when non-OPEC supply is lower, that puts upward pressure on oil prices and also gives OPEC countries a greater ability to influence oil prices.
[3] The Organisation for Economic Co-operation and Development (OECD) is an intergovernmental organisation with 38 member countries, founded in 1961 to stimulate economic progress and world trade.
[4] The Organisation for Economic Co-operation and Development (OECD) is an intergovernmental organisation with 38 member countries, founded in 1961 to stimulate economic progress and world trade.
[5] Source: www.opec.org; www.wikipedia.com; https://history.state.gov/milestones/1969-1976/oil-embargo
[6] Source: US Energy Information Administration www.eia.gov
7) Source: US Energy Information Administration www.eia.gov
2. GLOBAL OIL DEMAND
Economic growth is one of the biggest factors affecting petroleum product and therefore crude oil demand. Growing economies have higher demand for energy in general and especially for transporting goods and materials. The world’s transportation sector is almost totally dependent on petroleum products such as gasoline and diesel fuel. Many countries also rely heavily on petroleum fuels for heating, cooking, or generating electricity. Indeed, petroleum products made from crude oil and other hydrocarbon liquids account for about a third of total world energy consumption[7].
Where is oil demand the greatest? As of 2019, the United States used about 20% of the world’s oil. Much of this oil was used for transportation. China and India were the next biggest users, utilizing about 14% and 5% of the world’s oil production, respectively. They were followed by Japan and Russia at 4% each.
OECD Demand
The Organization of Economic Cooperation and Development (OECD) consists of the United States, much of Europe, and other advanced countries including Turkey. At 46% of world oil consumption by end of 2021, these large economies consume less oil than the non-OECD countries. While oil prices and OECD consumption have a close relationship, it is not necessarily clear which one impacts the other. For instance, while OECD consumption dropped due to higher oil prices during the 2008 crisis, oil prices dropped in 2020 and 2021 alongside the visible reduction in OECD demand during the Covid pandemic.
Source: US Energy Information Administration, Refinitiv An LSEG Business
Non-OECD Demand
Historically when the world has experienced higher GDP growth the non-OECD oil consumption has been higher and vice versa. Over the last two decades the largest reduction in consumption was in 2020 when economic activity came to a halt at the onset of the Covid pandemic. China’s strong economic growth has recently resulted in China becoming the largest energy consumer and second largest oil consumer in the world. Indeed, the increase in demand due to economic growth, particularly that of China, tends to overwhelm any downward pressure on oil consumption. The growth in population in non-OECD countries also supports strong oil consumption growth in the long run. EIA projects that virtually all the net increase in oil consumption in the next 25 years will come from non-OECD countries.
One of the roles of financial markets is price discovery, and as such, these markets play a central role in influencing oil prices. Commodities such as crude oil can be traded globally. Market participants can buy and sell physical quantities of oil as well as trade contracts for future delivery or buy and sell options contracts. Options allow for investment exposure with limited potential for losses and could provide a buffer against adverse commodity price movements.
Different market participants may have different motivations for buying or selling oil physically or with future delivery. For example, an airline may want to buy futures or options in order to avoid the possibility that its future fuel costs will rise above a certain level, while an oil producer may want to sell futures in order to lock in a price for its future output.
OIL PRICES ARE VISIBLY IMPACTED BY GEOPOLITICAL EVENTS AND WEATHER
That said, the relationship between crude oil and other financial markets is often complex and tends to change over time influenced by various factors such as geopolitical risks, inflation, economic growth and exchange rates. Oil prices are affected by events that have the potential to disrupt the flow of oil and its end products, including geopolitical and weather-related developments. These types of events may lead to actual disruptions or create uncertainty about future supply or demand, which can lead to higher volatility in prices
POLITICAL UPHEAVAL ALSO AFFECT OIL PRICES
One of the other main reasons for volatility in oil prices is because much of the world’s crude oil is located in regions that have been prone historically to political upheaval, or have had their oil production disrupted due to political events. For example it is not a coincidence that several major oil price shocks have occurred at the same time as supply disruptions due to political events, such as the Arab Oil Embargo in 1973-74 and other conflicts in Middle East.
Source: U.S. Energy Information Administration, Refinitiv An LEG Business.
Data as of 09/30/2022
Weather can also play a significant role in oil supply. Hurricanes in 2005, for example, shut down oil and natural gas production as well as refineries. As a result, petroleum product prices increased sharply as supplies to the market dropped. Severely cold weather can strain product markets as producers attempt to supply enough of the product, such as heating oil, to consumers in a short amount of time, resulting in higher prices. Other events such as refinery outages or pipeline problems can restrict the flow of oil and products, driving up prices.
Crude oil inventories act as the balancing point between supply and demand. During periods when production exceeds consumption, crude oil and petroleum products can be stored for expected future use. In the economic downturn of late 2008 and early 2009, for example, the drop in world demand led to record crude oil inventories in the United States and other OECD countries. Given the uncertainty of oil supply and demand, inventories are usually seen as a precautionary buffer. Therefore, when inventories are lower during periods of higher demand such as more recently, this could put upward pressure on oil prices.
The main issue however is lack of data. While OECD inventory data is available, inventory data for other countries is sometimes available with a lag or is not available at all which creates further uncertainty and volatility in oil markets.
Finally, in addition to the commercial inventories discussed above, the United States and other countries maintain strategic reserves of oil. The U.S. Strategic Petroleum Reserve, which is maintained by the Department of Energy, has the capacity to hold roughly 700 million barrels of oil that can be drawn upon by order of the President in the event of a supply disruption that meets specific statutory criteria. Members of the International Energy Agency, including the United States, collectively hold about 1.6 billion barrels of publicly owned petroleum stocks for emergency response.
SHORT-TERM CRUDE OIL OUTLOOK
RECENT OPEC+ CUT
Just eight countries will have to cut their output
Let’s now look at what happened more recently to get a sense of what might be expected in regards to oil prices in the near term. One of the most important developments is the OPEC+ group meeting that took place on October 5th. OPEC+ decided to cut their collective output target by 2 million barrels per day starting in November. While that is not a small figure on paper, it is somewhat misleading as the actual cut is likely to be much smaller than the target number. There are couple reasons for that. First, compliance of OPEC members with OPEC quotas is mixed because production decisions are ultimately in the hands of the individual members. In general, the main factors determining OPEC’s effectiveness in influencing oil prices include:
Sources: Bloomberg calculation using data from sources including OPEC
There is also the fact that this projected cut is based on “target” production level which is different and already higher than what the countries are actually producing. OPEC+’s September production estimates suggest that the actual production is already below the target levels by about 3.6 million barrels a day so the 2 million barrel cut would have only a negligible effect.
Therefore, of the 20+ countries in OPEC+ only eight countries are expected to reduce their output and bulk of this is to be shared amongst three — Saudi Arabia, the United Arab Emirates and Kuwait. As most of the other countries are already pumping below their quota levels that their output will still fall short of their new allocations. The markets at first didn’t welcome the news of reduced supply and WTI first month futures contract hit $92.64 on October 7th. However, as the data showed the actual cuts would be more marginal and the concerns about global slowdown and lower oil demand increased, oil dropped back to $85.
CONFLICT BETWEEN UKRAINE AND RUSSIA DISRUPTED THE SUPPLY LINES
In response to Ukraine-Russia conflict potential disruption to supply lines, in March 2022 US President Joe Biden unveiled his plan to discharge 180 million barrels in total from Strategic Petroleum Reserves to buffer the surge in prices for consumers. To date, about 165 million barrels have been delivered or put under contract since the program was put into effect. As of October 4th, the U.S. had 405.1 million barrels of oil in its Strategic Petroleum Reserves. The US uses these reserves to increase supply when necessary, such as when supply lines are interrupted after a natural disaster. US noted that they are prepared to conduct additional sales this winter if conditions require it, although the oil released from the reserves is expected to provide only a limited buffer given the world daily oil consumption was estimated at 94.4 million barrels at the end of 2021.
WOULD OIL PRICES GO UP OR DOWN?
In their Winter Fuels Outlook, EIA forecasts that average household expenditures for home heating fuels will increase this winter because of both higher expected fuel costs and higher energy consumption due to expected colder temperatures. Compared with last winter, in nominal terms, they forecast expenditures in the US for homes heat with natural gas will rise by 28%, heating oil by 27%, electricity by 10%, and propane 5% from 2022 October – 2023 March.
Considering the lower supply partially driven by the OPEC+ cut and the colder temperatures which would lead to higher demand, the broad market expectation is that by early 2023 crude oil prices will increase from $85[8] by 10-20% and move towards $100 per barrel despite the expected slowdown in global economy and the release of oil from US Strategic Reserves. This increase is expected to fuel the global inflation, dampen the growth and potentially drag the global economy into recession. The impact of higher oil prices is expected to impact oil importing countries, such as Turkey, more given the higher cost of purchasing oil with the increasing value of US dollar against most developed market currencies.
DECISIONS TAKEN BY EUROPEAN UNION REGARDING RUSSIAN OIL IMPACTED GLOBAL OIL MARKET NEGATIVELY
Another interesting development in the global oil market is the recent decisions taken by European Union regarding Russian oil. European Union is in a sensitive spot with about six weeks at the time of writing until the harshest sanctions on Russian exports[9] in history is about to take effect on December 5, 2022 to effectively put a price cap on Russian oil. US has tried to deter, though unsuccessfully, European Union regarding these aggressive bans given it could trigger a supply shock should the ban not work which could exacerbate the upward pressure on crude oil prices. To alleviate this pressure, Russia has been leaning on India, China and Turkey to maintain its crude exports. This could throw a lifeline to the countries hurt by higher oil prices but are exporting crude oil for Russia, such as Turkey. Turkey is a net importer of oil and has been suffering from declining Turkish Lira against the USD adding to its increased gas prices at the pumps and inflation woes. Inflation in Turkey hit 83% by end of September 2022 according to statistics Turkey. As of October 21st Turkish Lira had declined by over 28% against US dollar year to date.
[8] WTI first month contract price as at end of October 21 2022.
[9] The Council decided that in event that a vessel under the flag of a third country has transported Russian crude oil or petroleum products purchased at a price above the price cap, it should be prohibited to provide technical assistance, brokering services, financing or financial assistance, including insurance, related to any transport in the future by that vessel of crude oil or petroleum products. https://www.consilium.europa.eu/en/press/press-releases/2022/10/13/declaration-by-the-high-representative-on-behalf-of-the-eu-on-the-alignment-of-certain-third-countries-concerning-restrictive-measures-in-view-of-russia-s-actions-destabilising-the-situation-in-ukraine/
Sources: Bloomberg calculation using vessel tracking data monitored by Bloomberg
WHO WINS, WHO LOSES IN OIL?
Other winners of higher oil prices are expected to be the net oil exporters such as Saudi Arabia, Russia, Iraq, United Arab Emirates and Norway amongst others and net importers such as China and United States could be on the losing end. There is however a caveat – being a net exporter may not be sufficient to win in the complex game of petroleum products. Countries like Canada who produce more than they can consume but still import oil and byproducts due to various issues could be hurt seriously not only because of increased oil prices but also because of their less valuable currency against the US dollar given oil is priced in US dollars. Case in point, as of October 21st DXY index which is the value of US dollar against a weighted composite of Euro, Japanese Yen, British Pound, Canadian dollar, Swedish Krona and Swiss franc gained 18.1% in value year to date.
COUNTRIES WHO ARE ABLE TO BE LESS RELIANT ON OIL WILL BE THE WINNERS IN THE FUTURE
The same effect would be true and bigger for net importing countries like Turkey who have currencies depreciating against the US dollar and have small or no oil production to offset these losses. The winners of oil price increase will be those countries who can maintain or strengthen their economies and currencies during this period and who can match their internal oil demand with their own production and are able to be less reliant on oil going forward.
While it is difficult to gauge the net winners and losers of higher oil prices in the short run, one thing is certain – crude oil and therefore the global economy will likely be on a roller coaster ride for the rest of 2022 and into 2023 with the households being the losers of the game with higher bills and inflation.
Ela Karahasanoglu, MBA, CFA, CAIA
Ela Karahasanoglu is the CEO of EKR Total Portfolio Advisory based in Toronto, Canada. EKR advises global institutional investors and asset managers on alternative investment and portfolio construction from a total portfolio perspective. Previously, Ela was the Head of Total Fund Management team at BCI, one of the largest asset managers in US and Canada with assets over $200 billion. Ela has over 25 years of international investments and leadership experience. She has worked with global asset management, consulting and pension fund companies in London, New York and Toronto including UBS, Merrill Lynch, Mercer, CIBC Asset Management and BCI. Ela is a frequent speaker and a published investment thought leader in institutional asset management. Amongst the awards she has received includes the “Global Leading Innovator” in 2020 and “Hedge Fund Rising Star” in 2018 by The Institutional Investor, one of the leading publications in the institutional investment field. Ela is a graduate of Uskudar American Academy in Turkey and has earned her MBA from Georgetown University in 2000. She has been a CFA Charterholder since 2002 and a CAIA Charterholder since 2010. Ela serves as the Co-Head for CAIA’s Toronto Chapter since 2018. She is married and lives in Toronto.
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