The Always Fluctuating Supply and Demand for Oil

The demand for oil has significant effects on markets. Oil is a critical input to industrial goods and is an essential line item for many businesses, and the price has a substantial impact on consumer spending behavior. During geopolitical uncertainty, the price of oil can be very volatile and have significant effects on the global economy. Spikes in the supply or demand for oil can introduce considerable market volatility. For those who can effectively forecast the supply and demand for oil, there are significant returns to be earned. In this piece, we will consider the major inputs affecting the price of oil and the supply and demand for oil in the short and medium term.

Currently, oil sits at a price of about $80 dollars a barrel for Brent crude (a common and generally accepted oil futures quote). When considering where oil could go from here, the first step is to consider the global supply and demand dynamics. In the U.S., the strategic oil reserve is around 40% below historical averages, according to research from JP Morgan, and going forward, U.S. oil production is expected to be limited considering the interest rate environment and the cost of financing (new oil production tends to be very reliant on capex financing).2 It is generally accepted that OPEC will marginally increase supply, which has caused a bit more softness in the price of oil. But this supply can be quickly reversed, especially if the geopolitical picture continues to get more complicated3 although OPEC has publicly stated that as of right now there will be no immediate action.10

Demand for oil, on the other hand, has remained consistent. Clean energy alternatives are not yet mature enough to meaningfully impact oil demand.2 The International Energy Agency forecasted that in the longer term, demand for oil will peak in 2030, at which point cleaner alternatives will start to be feasible enough to reduce demand from traditional energy sources.9

Surprisingly, since the attacks on Israel on October 7th, the price of oil has remained largely contained. However, economists are still warning that we could see a significant increase in the price of oil due to long-term increased demand for oil and a potential shortage in supply. According to the World Bank, if the conflict in Israel spills over into the broader region, we could see oil prices surge by as much as 75 percent.4 While this forecast is initially surprising, the Middle East region accounts for about a third of the global oil market.5

There is a history of even greater surges in the price of oil. In 1973, following a very similar series of conflicts and challenged geopolitical relationships in the Middle East and following embargos from OPEC on exports to the U.S., U.K., Netherlands, Japan, and Canada, the price of oil surged 300%.5

Russia, another large oil producer currently involved in a conflict with Ukraine, relies heavily on the revenue generated from its oil production. The group of 7 (U.S., U.K., Canada, France, Germany, Italy, and Japan) has imposed a price cap on Russia's oil of $60 dollars per barrel. It has successfully penalized shipping companies that have skirted these sanctions.6 Officials believe that these sanctions have helped keep the price of oil down despite increased demand for oil, especially considering the conflict in the Middle East. Moreover, they have reduced the amount of money Russia can generate to fund their invasion of Ukraine.7 For obvious reasons, forecasting the outcome of the Russia-Ukraine conflict and the corresponding effects on the supply and demand for oil is nearly impossible. Still, it does illustrate how complicated the landscape around the price of oil is.

Oil production from the United States has surprisingly increased. In August of this year, it hit an all time high surpassing the previous peak set in November of 2019. Higher interest rates, higher inflation, and oil prices below $100/barrel have generally been less constructive for U.S. oil production, which generally requires lower financing costs and higher oil prices for the economics to be compelling. However, the United States has seen a pickup in drilling efficiency. The number of barrels produced per day has increased while the number of active rigs drilling has increased nearly 20% year over year.8

Simply put, the geopolitical and macroeconomic uncertainty suggests that the price of oil could be a coiled spring ready to explode to the upside if there is continued uncertainty. A simple catalyst could cause the increase in oil prices to resemble the 1973 oil crisis. While higher prices would undoubtedly harm consumers, anytime there is this much potential volatility, we consider investment managers who have a history of successfully investing in the energy sector, oil futures, and challenging macroeconomic environments.

At Crystal Capital Partners, we work hard to make sure we have an adequate roster of managers who have a history of navigating volatile markets and believe that alternative strategies can provide important diversification in a market with so many unknowns.

Sources:

1. Oil price jumps to $89 a barrel following Hamas’s attack on Israel (ft.com)
2. Will oil prices keep rising? | J.P. Morgan Research (jpmorgan.com)
3. Oil Prices Jump on Fighting in Israel and Gaza - The New York Times (nytimes.com)
4. Middle East War Could Cause Oil Price Shock, World Bank Warns - The New York Times (nytimes.com)
5. Fuel for Thought: A Middle East oil embargo is irrational, not unthinkable | S&P Global Commodity Insights (spglobal.com)
6. U.S. Clamps Down on Russian Oil Sales With New Sanctions - The New York Times (nytimes.com)
7. Russia's War on Ukraine – Topics - IEA
8. US oil output hits record as producers boost drilling efficiency | Reuters
9. World oil, gas, coal demand to peak by 2030, IEA says | Reuters
10. OPEC plans no immediate action after Iran urges Israel oil embargo, sources say | Reuters