OPEC+ is prepared to defend $80/bl, but economic weakness and potential supply kept off the market will likely limit any upside as consumers acclimatise to higher prices, says Saxo Bank’s Ole Hansen
Elevated oil prices may be here to stay for the medium-to-long term, but it would have to take extreme geopolitical risks to push prices into triple digits in the immediate future, according to Ole Hansen, head of commodity research at Danish investment bank Saxo Bank. The oil market may well have found a new sweet spot in the $85–95/bl range, with consumers adjusting to the new price level and producers such as OPEC+ willing to defend a floor, Hansen told Petroleum Economist.
The cross-commodity specialist also provided a reminder that energy prices drive inflation, not the other way around, and that higher commodity prices can persist in a recessionary period.
What drives oil markets more, the macro- or microeconomic fundamentals, or metrics such as US stocks etc?
Hansen: The oil price is always supply/demand driven. And in a normal situation, that would be driven by economic fundamentals and the strength of the economy at a given time. But what we have seen increasingly in recent years is that the micro also plays its part. We have an assertive group of OPEC+ producers right now helping the price along, ensuring what they call a stable and balanced market.
“Energy prices have been driving up inflation, but next year they could have the opposite impact”
The market is probably not that stable or that balanced at the moment, and we have seen prices move higher as a result. In terms of the US numbers, they tend to be in focus simply because it is the only place where we have real live data giving us some insights into the outlook. That has obviously changed in recent years, because we have all these tanker trackers giving us almost live data in terms of shipments leaving and arriving at ports. That does give us some insights and takes some of the weekly volatility out of numbers from the US, because we have other data to lean on.
But right now, we have the dreadful situation in the Middle East, and the market is trying—so far with a great deal of difficulty—to price in what it means for oil prices, because we have a market where fundamentals are starting to show signs of weakness. We have seen refinery margins come down and we are into the low season in terms of demand, and that leaves more oil in the tanks and adds some downward pressure to prices. But at the same time, we are trying to quantify the impact of a supply disruption, and that is where it becomes difficult. We are seeing these $5–10/bl moves right now, which is because the market is really struggling to find out what legs to stand on.
And how do you price in a ‘risk premium’ and separate it from the fundamental drivers of the oil price?
Hansen: It is extremely difficult; you are potentially paying a price that is not going to stick around if some of the worries that you are pricing in do not materialise. And that is why what we are seeing is that the geopolitical risk premium can be added fairly quickly. We saw that at the beginning of October, and at one point it probably reached $10/bl. Now it has settled in and is more like taking $5/bl out of the market and adding it back in again, depending on the news flow. That is probably the current premium. But we also know we would not be at $90/bl if we did have a major disruption, we would probably be at $100+/bl. So it is almost like optionality, in that you are prepared to pay a premium to get an option for a significant upside. But at the same time, you are doing a delta hedging as soon as there is some news pointing in the other direction.
We have seen that for the past three weeks, where Fridays have been really strong for the oil market. We have seen rallies hedging any weekend risk only to be selling off on the Monday when the news was not as price-supportive as feared. We saw with the Russian invasion of Ukraine how the market really got wrong-footed. It is the same with the gas market in Europe. At no point in this scenario did we run out of oil anywhere in the world. We did not run out of diesel or gasoline anywhere in the world, or out of gas. But, nevertheless, the market priced in some extreme levels and some extreme risk. We learned from that lesson that these premiums are difficult to price but that, at the same time, they can really be taken out very fast because you are pricing in something that has not materialised.
The big theme for the past year or so has been inflation and interest rates, and the drivers for oil prices. If demand stays strong, it means higher inflation, which also feeds into higher interest rates. In one sense that could be seen as bullish, and in another sense it could be seen as bearish. How do you see that interplay between inflation, demand, interest rates and oil prices, and how you think that may play out going into 2024 and beyond?
Hansen: Energy prices are a major source of the inflation focus. We saw that early this year when Saudi Arabia and Russia announced production cuts, oil prices started to move higher, and that triggered a sell-off in the bond market—basically on worries that inflation was going to stick around for longer and be more intrinsic and more difficult to bring under control.
“We can have higher commodity prices even though we have recessionary or weak growth outlooks in certain areas of the world”
Energy is more the driver of inflation than inflation is the driver of energy. And that obviously means that—if higher energy prices drive inflation and thereby force central banks to apply the brakes even harder—at some point the impact will be negative. And that is potentially what we are looking at next year, where we are seeing signs of weakness in Europe already. US growth remains phenomenal relative to expectations, but at the same time, we are also seeing some signs of an economic slowdown starting to materialise. That is also partly the reason why the oil market is really struggling to hold on to these risk premiums, because there are some worries about an incoming slowdown. So far, it is only seasonal. Whether it is more structural remains to be seen.
But the impact of what we have seen over these past few years—with very high inflation driving up bond yields to the highest levels in more than 20 years—will eventually hurt the economic outlook and, with that, also potentially demand for energy. We will focus a lot on Asia because growth is still coming from there, especially China and India. It is important to see how China manages to get its economy under control, especially the property sector and the whole debt situation. So, for now, energy prices have been driving up inflation, but next year they could have the opposite impact.
At what point does demand destruction kick in and do you agree with the adage that the cure for higher oil prices is higher oil prices? What about the parable of the boiled frog: slow price rises do not bother consumers—only sharp rises—until we get to an absolute high number, and that then kills demand.
Hansen: Yes. It is more the shock of a sudden spike than the slow-moving price rise that the market and consumers respond to. We saw that with the gas crisis in Europe, where consumers really stepped up. They found their woollen jumpers and all sorts of measures to cut demand because prices had spiked. At current levels, oil prices—and with them diesel, gasoline prices and heating fuel prices—are probably not negatively impacting demand that much.
Although we have obviously seen the softness in the US gasoline demand, implied demand figures over the past couple of months potentially indicate we have reached a level where some consumers are having second thoughts about their habits. But I think, at this point, we probably need to see prices higher. At the same time, crude oil prices are one thing, while the margins for gasoline, diesel, jet fuel and so on are another. And they obviously have been extremely high. So while crude oil was lingering in the $80/bl region and low $90s/bl, we had gasoline and diesel trading somewhere above $100/bl or equivalent. That is really what we should keep an eye on.
Part of the issue in the energy market is not only the availability of crude, but also the availability of refinery capacity to make enough fuel available, because we are looking at a number of years where demand, if anything, is still going to remain firm—perhaps still seeing small increases. We are seeing the punitive negative impact that the high interest rates have on the green transformation. A lot of these projects are struggling because of rapidly rising funding costs, and that potentially could delay the transformation process. That would leave us dependent on fossil-based energy for longer than we might otherwise have expected. That is part of the story as well.
What is your take on the idea of a supercycle? Will prices stay elevated for longer?
Hansen: What drives the supercycle? It is not only a question of demand remaining strong, but also of supply keeping up with demand. The prospect or the risk of higher commodity prices in the coming years is most certainly one that we favour over lower commodity prices. Part of that is demand for some commodities—energy, in particular, and also industrial metals for the green transformation. They will remain strong. At the same time, we have all this debate about investments—whether they are strong enough to ensure we continue to find the oil required in the medium-to-long term. And I do understand, if you are an oil major and are looking at projects that may not start to pay back on your investment for another five years, are you prepared to take the risk if peak oil is around the corner? That is the big dilemma that oil majors have, because at the same time they also have to show greener credentials, so they have to divert investments towards green projects. Overall, that could potentially leave the market in a relatively tight spot in the coming years until we see that peak demand.
“That $75–80/bl range is a major line in the sand that will be defended [by OPEC+] if we return to that level”
The energy sector will stay supported and industrial metals will stay supported, but we have a relatively uncertain world right now and that is not going to go away. The fragmentation we are seeing in all trading and political relationships is something that plays into those looking for alternative investments in gold and other precious metals, for example. So, generally, we believe the cycle towards higher prices following the correction we had from the record peak last year—which lasted for more than six months and has now started to show signs of recovery—will continue in 2024. We can have higher commodity prices even though we have recessionary or weak growth outlooks in certain areas of the world.
What makes a balanced oil market? Is there a sweet spot for oil prices, one where producers and consumers are kind of happy? It seems to be a moving target.
Hansen: The only thing we can conclude for now is that there is a floor in the market, or at least there is a perception of a floor that will be defended by OPEC+. They fought tooth and nail, and they yielded the revenues and cut production, to keep prices above $80/bl. That $75–80/bl range is a major line in the sand that will be defended if we return to that level. For now, it looks as if there is a sweet spot in the market where it is not too cold for the producers and not too hot for consumers, and that is probably in this $85–95/bl bracket. That will shift over time, but the sweet spot is also about getting used to a certain level. And it seems as if we are getting used to this kind of level. Then we have the swings in refinery margins that ultimately probably add the biggest level of volatility to what we are paying at the pump and how consumers perceive the price we have to pay for energy.
So right now we have a sweet spot but most certainly not a balanced market. The market is also always forward-looking to a certain extent, and there is looking to be some economic weakness, which is also important. We have not talked about speculation, which is a controversial topic. I was a speculator for a number of years when I traded in London, and I know the kind of liquidity speculators bring to the table, which makes it all go around for everyone. At the same time, speculators do not start moves, they amplify them.
Where do you see oil prices going in 2024?
Hansen: More of the same of what we have right now. I am probably a bit more in the Citibank camp, in terms of the potential weakness going into next year, because the market will start to try to figure out when Saudi Arabia can add the barrels back in, having obviously yielded market share. How would that scenario look? Potentially, it could add some downward pressure on the price. But the geopolitical situation is on top of everyone’s minds right now, and that will keep prices at these levels with the risk of an upside spike. But generally, I see it in this $80–95/bl bracket into next year.
Source: Petroleum Economist
