Let’s start with a brief introduction. Prices in any commodity market are primarily driven by supply and demand fundamentals, and the oil market has proven no exception. The relationship appears to be strikingly simple: when supply is lower than demand, upside price pressure accumulates; while the opposite is also true – i.e., when supply is higher than demand, downside price pressure builds. Yet, commodity markets with ample and measurable inventories have an additional and crucial feature – in fact, futures contract prices show a tight relationship with the expected changes in the underlying commodity inventories. Inventories that are expected to decline are usually associated with backwardation, which occurs when prices of futures contracts decline as the contract expirations move into the future. As an example, oil markets were in steep backwardation in 2022, as traders were anticipating declining inventories due to sanctions being imposed on Russia, a major oil producer, after its invasion of Ukraine. Vice versa, inventories that are expected to increase are usually associated with contango, which occurs when prices of futures contracts increase as expirations move into the future. An example of contango occurred in the immediate aftermath of the Covid-19 pandemic when traders became concerned about the extent of the oil demand collapse.

Additionally, ‘non-fundamental’ factors, meaning those that cannot precisely be associated with changes in oil supply and demand, such as recessionary fears, geopolitical risk, and market speculation also drive the price – and the impact of non-fundamental factors in the oil market tends to be tangible. Yet, the boundary between what may be considered a ‘non-fundamental’ factor and a fundamental one is not always clearly defined: for instance, it may be argued argue that, since recessions are historically associated with lower demand, a recession risk ultimately represents a fundamental oil demand factor, which leads traders to take a bearish view on prices. This expectation in turn materializes into a contango term structure for oil prices. By the same token, a risk of geopolitical instability in oil-producing countries usually sees traders adopt a bullish view on prices, on the basis that oil supply typically ends up being curtailed in the presence of political and social turmoil. Think of the Arab Spring in the early 2010s, when the anticipation of lower oil production ended up materializing in Libya but spared other oil-producing countries in the region. In turn, this bullish expectation usually generates a backwardated term structure.

For the purposes of this article, we will not attempt to disentangle this conundrum between fundamental and non-fundamental factors, but will simply assume that non-fundamental factors find their way in the oil price formation process either directly, via term-structure considerations, or indirectly, via risk premium considerations – or indeed a combination of the two.

Having put some margins around the role of non-fundamentals, let’s now start with an analysis of the fundamentals. Rystad Energy’s latest liquids supply and demand balance shows the oil market will move to a significant deficit starting this month, averaging a steep 2.4 million barrels-per-day (bpd) deficit for the rest of the year. The last time such a degree of deficit was seen in the market was between the second half of 2020 and the first half of 2021, when oil prices increased from $44 to $69 per barrel. Similarly, between the second quarter of 2017 and the same period of 2018, the market was undersupplied by around 2 million bpd and prices increased from $51 to $75 per barrel.

The key question is, therefore: given the expectation that the oil market will tighten significantly for the rest of the year, why are prices not higher than they are currently? Is it due to non-fundamental factors, such as the risk of a recession, or because demand is currently lagging? Or is it because supply is stronger than we think?

Rystad Energy’s assessment is that it is a combination of all three of these. Let’s tackle them in succession.

Demand: is growth still as robust as we believe? Bottom line, yes, but downside risks still loom

In our Base Case, we forecast that oil demand will increase by 1.7 million bpd in 2023. This growth rate is relatively conservative when compared to other main forecasters – both OPEC and the International Energy Agency (IEA) forecast demand to grow by around 2.4 million bpd, however the US Energy Information Administration (EIA) has it at 1.6 million bpd.

Our growth forecast this year has mainland China (from regional point of view) and jet fuel (from a global product point of view) as the main growth engines. Mobility data is a precise indicator of the actual evolution of demand. The latest mobility data shows mixed signals. Global road traffic has fallen below 2019 levels in the last couple of weeks after remaining above those levels for more than three months. Most of the decline seen recently is concentrated in China, Europe and North America. China has been dealing with another wave of Covid-19 for the past month, which has kept some people voluntarily at home, albeit without any lockdowns. We expect this effect to be temporary. Germany, the UK and the US have also seen road transport decline, but it is too early to tell whether this is a structural shift or not.

As for aviation, we have seen some contrasting signals, with China recently dropping below 2019 levels and the rest of the world unable to increase above 90% of 2019 levels for the past three months. Yet, as explained in a recent Rystad Energy commentary, we still forecast aviation to perform strongly in the second half of the year.

Much of the global demand outlook will then hinge on China’s economic performance in the second half of this year, and that in turn will depend on the effectiveness of the stimulus measures recently announced by the Beijing administration. To a lesser extent, the global demand outlook will also be a function of the US and Europe’s ability to avoid an economic slowdown amid interest rate hikes.

Supply: tight control by OPEC+ but have promises been broken? Not yet

In April this year, seven OPEC+ countries, led by Saudi Arabia, introduced voluntary production cuts running from May until December 2023 and amounting to 1.15 million bpd. Additionally, Russia announced in March that it will voluntarily reduce production by 500,000 bpd until the end of the year.

The latest production figures for May show something of a glass-half-full picture. Whereas output from the group of seven countries did drop last month, it was by slightly less than promised – while the promised cut was 1.15 million bpd, production declined by less than 900,000 bpd. In the case of Russia, there is also a gap between actual and promised cuts in May – out of the announced cut of 500,000 bpd, production has actually declined but only by 400,000 bpd, a whole 20% less than pledged.

In fact, the case of Russia is particularly significant – and somewhat puzzling. While production has declined – albeit by less than the announced amount – with respect to the February baseline, seaborne crude exports have increased since then. In February, Russia was exporting around 3.3 million bpd, while in recent weeks exports have averaged around 3.5 million bpd. This mismatch has added uncertainty to the market with respect to actual Russian production. We believe that the mismatch is explained by the use of stocks; however, given the limited Russian storage capacity, there is little room going forward.

Interestingly, if this mismatch between high exports and alleged production cuts by Russia keeps going, the potential reaction by the rest of OPEC+ could radically shift the supply dynamics. In fact, just remember what had happened right before the onset on the pandemic in early 2020, when Saudi Arabia and Russia briefly engaged in a price war, with both countries increasing production to unprecedented levels. This game of chicken was, thankfully, over after just one month as the necessities presented by the pandemic kicked in, which forced OPEC+ to cut aggregate production by more than 13 million bpd – equivalent to 60% of the global oil demand drop at that time – and drove member countries to engage in cooperative behavior for the ensuing 36 months. Therefore, if the last three years are any guide, we could confidently assume that similar tit-for-tat behavior within OPEC+ is a low-probability event – although it must also be conceded that it is nevertheless one with high-impact potential, which could drive oil prices into bearish territory.

Other sanctioned countries – namely Iran and Venezuela – may also be adding uncertainty to the supply side, particularly because of the opaque nature of their exports. In the case of Iran, market expectation a few months ago was that there would be increasing competition in the dark fleet tanker market with Russia (as a result of the G7 price cap on Russian crude) so that Iranian crude exports would drop. In reality, Russia has not needed to tap into the dark fleet market as much as expected, implying that Iranian exports must have been stronger than anticipated.

Non-fundamentals: are high inflation and high interest rates dragging oil prices? Yes, but they have been slowing

Energy commodities have in recent months underperformed compared to other asset classes. The key reason for this does not rest with fundamental commodity dynamics but is instead heavily influenced by the prevailing macroeconomic environment and asset allocation decisions, which have been driven by high interest rates and high inflation.

US interest rates have risen to their highest levels since the 2008-2009 financial crisis in an effort by the administration to tackle soaring inflation. This policy has had a profound impact on asset allocation strategies – in the current environment marked by recessionary fears and even financial uncertainty, there has been a shift in asset allocation from riskier assets to safer ones. At the same time, soaring inflation last year meant that commodities – notably crude oil – were used as a means of inflation hedging. Since the start of the year, with inflation already peaked and declining, and oil prices not growing, the incentive for such a hedging strategy through oil has dropped. Partly because of these asset allocation decisions, speculative positioning on the oil basket plummeted to its lowest levels since the peak of the pandemic in 2020.

Another critical development has been the direct impact that higher interest rates have been having on opportunity costs in the physical markets. In fact, higher interest rates have led to an increase in the cost of holding oil stocks, which manifested in global crude and condensate volumes in floating storage declining in the last few months from around 80 million barrels in January to less than 65 million barrels in April, its lowest level since early 2020, information from the IEA shows.

Will oil hit $90 per barrel any time soon?

We believe that market fundamentals will return to the driving seat as far as the oil price formation is concerned in the coming weeks. Why do we have such a strong conviction? At the end of the day, it boils down to the strength of the signal coming from global supply and demand balances, which we forecast are pointing to fast-declining inventories starting this month. In fact, swiftly dropping oil inventories will not only contribute to generating a steepening backwardation, which will raise the front end of the Brent curve and therefore spot prices, but they should also help dissipate the uncertainties associates with the non-fundamental risks we have highlighted above.

Yet, as we stick to our guns for our oil price outlook for the second half of the year, it is also crucial that we briefly summarize here what the building blocks of such an outlook are, and identify the risks associated with each of them. First, our balances point to more than 2.4 million bpd of stock draws starting in June. About 70% of these draws are directly tied to OPEC+ announced production cuts in April, which in aggregate amount to near 1.7 million bpd of lost supply. While we maintain that lack of discipline within OPEC+ is a low probability event, we cannot just rule it out. Second, oil demand is expected to grow by more than 2 million bpd in the second half of this year, of which just over 1 million bpd is due to the global aviation industry recovery and around 1 million bpd due to China’s economic recovery. Yet, while we think global aviation is in robust shape at least through the end of the year, we recognize China’s economy hangs in the balance, and much will depend on the effectiveness and depth of the economic stimulus announced last week. History shows that Beijing usually succeeds in reviving China’s planned economy through stimulus packages, but the size of the problem – namely a bloated and badly funded real estate sector – continues to grow. Third is OECD recession risks. The non-core inflation rate in the US dropped to 4% in May, prompting the Federal Reserve to hit pause on rate hikes, while a persistent gap between European Central Bank (ECB) interest rates and Eurozone inflation rates will likely force the ECB to continue tightening. Recession is a word that we have heard and read so many times in the past 12 months that it may seem surprising it has so far failed to materialize. Yet, high interest rates have in the past frequently triggered recessions in both Europe and the US, which means that the so-called ‘soft landing’ being pursued – and arguably in the process of being achieved – by central banks would in fact be a relatively unusual event.

In a nutshell, we remain confident that a significant upside price pressure will come to fruition in the second half of the year via fast declining oil stocks. This outlook hinges on the assumption that the three main sources of downside risk – namely OPEC+ non-compliance, China’s slowdown and OECD recession – will unlikely materialize in the next six months.