A surge in demand, fading omicron concerns, and OPEC+’s inability to increase output have all contributed to an impressive rally in oil prices.
Since November, Brent crude oil has increased 25% to $88 per barrel. Some market participants now believe it is now a matter of when, not if, oil reaches triple digits. This has not been the case since 2014.
Goldman Sachs Group Inc. stated this week that prices will reach $100 in the third quarter. This is due to consumption surprises to the upside. On Wednesday, the Brent December contract’s $100 call options cost also soared to an all-time high.
The crude oil at this level would increase the already high inflation pressures in the global economy. This would cause problems for central banks as well as governments. However, it’s not an easy task. The U.S. shale is returning and could contain the rally. All eyes will be on China to see whether omicron can penetrate the Covid-19 defences, which have so far been mostly invulnerable.
Here’s a closer look into how oil got here, and where it is likely to go next.
Demand marches onward
Oil has more than recovered since the late November discovery of omicron, which revived memories about delta and sent Brent plunging below $70 per barrel. Due to the mildness of this variant, the high vaccination rates in most of the developed countries, and the general reluctance of imposing harsh lockdowns, a significant hit to consumption did not occur.
Spot market cargoes are in high demand, and at significantly higher premiums. The same is true for product space. The Asian energy hub Singapore’s middle-distillate stockpiles have dropped to their lowest level since 2013. The world is running out of diesel. Even jetfuel, the most affected by the pandemic, is starting to recover as long-distance travel resumes. It’s difficult to imagine a reversal in demand, with the exception of a serious virus outbreak in China (see below), or a terrifying new strain.
No Supply Buffers
According to Kayrros oil analytics firm, global crude stockpiles fell back to pre-pandemic levels early in January. The drawdowns were led by sharp declines from China and the U.S. where inventories have been at their lowest level since late-2018. Due to tightening supply, oil’s market structure has fallen deeper into backwardation. This means that prompt oil is more expensive than long-dated contracts. This further reduces the incentive for oil storage for future sales.
According to Amrita Sen (chief oil analyst at Energy Aspects Ltd), the market has no supply buffers. This makes it more vulnerable to price spikes caused by supply shocks. But we don’t have this luxury.”
Also see: The Dwindling OPEC+ Reserve Capacity Makes It Possible to Get Oil for Sizzling Summer
OPEC+ Struggles To Pump More
Officially, OPEC+ has been restoring production at a rate of 400,000 barrels per day every month. In reality, however, the alliance is not achieving this goal. African members are particularly struggling to increase production. OPEC added only 90,000 barrels per day in December after a Saudi Arabia supply boost was offset by losses from Libya and Nigeria. Russia, which is part of the larger alliance, said that it may not be able to deliver all of its planned supply increases in the next six-months.
These supply problems are likely to play a significant role in pushing oil towards the $100/barrel mark. Iran could be a risky player if the long-running nuke talks are concluded and allow for an increase in crude oil exports. The market impact may not be as significant as it seems, as many shipments from Iran and Venezuela are already making their way towards China despite American sanctions.
U.S. Shale Response
The U.S. oil production has been rising, but it isn’t enough to slow the price rise. The December record supply from the Permian Basin, America’s most prolific and productive shale area that spans Texas & New Mexico, rose to an all-time high. Drillers looking to cash in on rising oil prices will find the Permian attractive. However, higher overheads and supply chain snarls have hindered a quicker ramp-up of activity.
According to Baker Hughes data, the number of oil rigs still in operation in the United States has increased to close to 500, up from 200 in the second quarter of 2020. However, it is still 200 less than the levels of March that year. U.S. shares are up U.S. energy companies are soaring as oil prices rally, but the main question is how shale drillers will spend the extra cash this year to increase production.
China Virus Wildcard
China’s zero-Covid policy, which includes draconian city lockdowns, has so far prevented a larger outbreak and an impact on oil demand in the world’s largest importer. The approach will be tested by Lunar New Year celebrations, when many Chinese return to their hometowns in less than two weeks, and the Winter Olympics in Beijing from February 4-20.
Omicron cases were reported in Beijing and Shanghai, as well as Shenzhen. Eurasia Group ranked the possible failure of China’s pandemic strategy the highest global political risk for 2022. Beijing may not be able control the highly transmissible variant the same way that it has stopped previous outbreaks. It may also be considering withdrawing from covid-Zero. The most interesting wildcard for oil prices in the coming months is a big virus that has impacted China’s economic growth and energy consumption.
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