To The Moon

Summary

• Weakness in crude, driven by China and Middle East cease-fire hopes.
• OPEC facing a pivotal decision on production increases.
• Outlook for U.S. inventories and Strategic Petroleum Reserve.
• Goldman Sachs said hedge funds have been dumping oil-consuming stocks to buy energy firms for a fourth week.

bymuratdeniz

Oil has bounced for a fourth time at a cluster of supports that have contained the crude price bottom around $72.00 since February. In this article, I will discuss why I see a rebound in black gold.

Weakness in crude driven by China, Middle East

Despite a bounce in crude oil this week, prices are still down around 11% since July. Much of the weakness in crude oil has been driven by two themes: Hopes for a cease-fire in the Middle East and a weak Chinese economy.

On the first issue, it appears that the expected ceasefire deal has collapsed within recent days. U.S. officials remain in Egypt over the weekend after some "constructive" progress, but there is still some confusion. With oil trading at prices near its 2024 lows, I believe that the risk is to the upside from here. With a ceasefire deal in place, traders will be forced to shift their focus to other factors.

Chinese GDP Growth (Trading Economics)

In the Chinese economy, investors have been anxiously following the quarterly GDP growth figures, looking for a breakout boom in the country. However, a weak global economy is making that hard for China. Despite this, the country's GDP is still solid with an annual rate of 4.7% currently.

Monthly weakness in China's oil demand is likely to be outweighed in the longer term by fast growth in the country's petrochemical sector. The IEA Oil Market Report for August noted that Chinese oil demand had contracted for a third consecutive month in June, with the trend likely to continue in July.

However, the group noted the shift in the country's petrochemical sector in a December article.

Driving this change is a towering wave of new petrochemical plants, most notably in China. This is shifting oil demand to the country as it increases production of plastics and synthetic fibers, while generating increasingly cutthroat competition among those that previously dominated the market.

The speed and scale of the expansion of China's petrochemical sector dwarfs any historical precedent, roughly doubling the pace of earlier capacity additions in the Middle East and the United States. Between 2019 and 2024, China is set to add as much production capacity for ethylene and propylene - the two most important petrochemical building blocks - as presently exists in Europe, Japan, and Korea combined.

I believe that crude oil's China-related woes are short-term, and the emergence of huge petrochemical capacity can be a driver of future demand.

OPEC facing a pivotal moment

A few weeks from now, Saudi Arabia and its Organization of the Petroleum Exporting Countries (OPEC) allies will have an important decision to make on their planned production increases from October. The group may postpone those cuts due to the recent weakness in the U.S. and European economies. The group has enforced production cuts on its members since late 2022 to drain excess inventories and boost prices.

Oil prices are now trading around the same price as they were at the group's last meeting on June 6. An extension to the production cuts could make this a floor in oil prices. Dark clouds have formed since the group's announcement in June.

The slowdown in the economy, alongside some weakness in oil demand, has also been met by an increase in production in the United States, Canada, Brazil, and Guyana.

OPEC has recognized the growing problems and has cut its 2024 oil demand forecast in the last two weeks. OPEC now says that world oil demand will rise by 2.11 million barrels per day in 2024, down from growth of 2.25 million bpd expected a month prior.

In the next few weeks, we could see oil move higher on OPEC member comments, or other developments that could lead toward an extension to cuts. The IEA noted in December that the OPEC group now only controls half of the global oil market, and I believe they are likely to defend their territory than in previous years.

The important factor at current prices is that oil officials publicly noted a price of $80 as the line in the sand. That is said to be the price where Saudi Arabia breaks even on its government spending and import bill.

Flooding the market with OPEC oil at a time of slowing global growth and growing oil competition seems highly unlikely in my view.

The outlook for U.S. inventories and the SPR

Despite the surge in production in the United States, much of that is being soaked up by overseas customers, as Russia and Iran have had to adjust their export strategy due to Western sanctions.

The EIA said in its weekly inventories report to August 16 that U.S. stocks decreased by 4.6 million barrels from the previous week. At 426.0 million barrels, crude oil inventories are around 5% below the five-year average for this time of year. Gasoline inventories were also lower by 1.6 million barrels and 3% below their five-year average for the same period.

If we look further out, we can see that crude and petroleum stocks are trailing lows going back to 1990 despite a huge increase in U.S. oil production.

U.S. Crude Inventories (EIA)

U.S. crude oil exports grew by 13.5% last year, but are expected to slow with global economic weakness.

The other factor for U.S. stocks is the continued desire to refill the country's Strategic Petroleum Reserve (SPR).

The Biden administration has signed up for $6 million barrels to be delivered to the SPR into 2025. Investors should also consider the potential for a change in policy with another Trump administration.

SPR Change with Presidents (EIA)

Although Trump did not make refilling the SPR a priority, the more fossil fuel-friendly President may be unhappy with the current level of depletion.

Finally, the Federal Reserve looks set for a cut to interest rates in September, which can boost oil prices, but officials at the central bank are still talking of a "gradual and methodical" approach to reducing borrowing prices.

The downside risk for oil prices would come from a larger deterioration in the global economy. With prices near 2024 lows, I believe that a Middle East ceasefire has been largely priced in by markets over the last month.

Analysis from Goldman Sachs this week has also shown that hedge funds have been selling stocks of fuel-consuming firms such as airlines and loading up on energy stocks for a fourth straight week. This suggests a directional bet on energy in the months ahead.

Conclusion

The price of crude oil hangs in the balance around the lows of 2024 and the stage is now set for OPEC and its allies. The group's previous commitment to lifting its production may be abandoned, or altered in the coming weeks, due to various factors. Slowing economic growth in China and the global economy has shifted the group's demand forecast for the year, while other nations have increased production. The big issue is the current price near $75, which may not please Saudi Arabia's rulers. Flooding the market with OPEC oil when demand is weakening could push oil further away from its breakeven comfort zone of $80. For that reason, I believe the group will change its plans for production cuts and is the key reason oil prices can rebound from here.