Since the latter part of July, oil prices have bounced around from highs to lows approaching a difference nearing $20/bbl because of the competition between factors that are both positive and negative for oil prices.
Concerns about China’s economy and the influence on the extent of oil demand growth has been a recurring theme for many months. The data surrounding the performance of China’s economy continue to disappoint as China struggles with weak domestic demand and less favorable export markets, coupled with a substantial decrease in foreign direct investment, within the context of excessive debt, especially with respect to the real estate sector.
Consequently, the oil market responded favorably to China moving forward with a stimulus plan that includes lower interest rates and the issuing of 2 trillion yuan (around US$285 billion) of special sovereign bonds. Additionally, China’s central bank reduced the reserve requirement ratio by 50 basis points, which will add 1 trillion yuan (around US$142 billion) into the banking system.
While the announcement of a stimulus plan provided an immediate boost to oil prices, the lack of any further announcement of additional stimulus measures, plus more disappointing economic data associated with the official Purchasing Managers Index (PMI) for September—for the manufacturing sector, as well as for the non-manufacturing sector—put downward pressure on oil prices.
Besides the concerns about oil demand, there are also concerns about oil supply—mainly because of the uncertainty surrounding OPEC+. At the beginning of June, the members of OPEC+ agreed to maintain their supply cuts through 2024 (including Saudi Arabia’s voluntary cut of 1 MMbbl/d) and then unwind the cuts during 2025. The associated concerns were magnified when it was reported that Saudi Arabia is ready to abandon its $100/bbl crude target in exchange for an increased market share.
The U.S. economy is also adding to the volatility of oil prices. The Federal Reserve decided at its September meeting to reduce interest rates for the first time since 2020 from a range of 5.25% to 5.5%, to 4.75% to 5% with a cut of 50 basis points, instead of the more typical 25 basis point cut, along with signaling that more rate cuts are on the way.
The better-than-expected jobs report for September, which showed the U.S. economy added 254,000 jobs, plus other positive economic news, however, created the possibility that the Federal Reserve might be more cautious about the pace of interest rate reductions. As such, the dollar strengthened against other currencies, which tends to put downward pressure on oil prices.
Besides the above factors, the influence of geopolitics on oil prices has been shifting. For most of the year, the influence of the military conflicts on the oil prices has been muted because the flow of oil has continued for the most part unabated, resulting in the oil market dismissing the potential risks. That risk, however, came to the forefront with the exchange of attacks between Iran and Israel and the possibility of a wider and more intensive conflict breaking out in the Middle East.
Stripping away the noise, we think that oil prices will be supported by more favorable supply/demand fundamentals and that the price of Brent crude oil will move back above $80/bbl during the fourth quarter.
From a supply-side perspective, it our view that Saudi Arabia leaked about taking back market share as warning to the market that Saudi Arabia is not willing to take on the burden of reducing production to support oil prices by itself—and not as an intention to crash oil prices. This warning is meant mainly for other members of OPEC+—especially those who have been overproducing and have promised to reduce future production to account for their earlier overproduction but have yet to do so—because It is imperative that OPEC+ exhibits cohesive and disciplined behavior to maintain credibility, especially when the sentiment of the oil traders is already very negative.
The warning is also for non-OPEC producers—including U.S. shale producers. Saudi Arabia wants to make sure that these producers consider the risk of significantly lower oil prices when making capital investment decisions. From a demand-side perspective, we are forecasting that demand will outpace supply during the fourth quarter with our forecast for demand growth being 1.2 MMbbl/d for 2024.
Oil prices will also get some support from the geopolitical uncertainty; however, not to the extent implied by the price action in the immediate aftermath of Iran’s missile attack on Israel. It is our view that the initial price movement was a market overreaction, in part, because we think Iran will continue to show restraint in responding to Israel since Iran is not interested in a major conflict with the Israeli military that will be supported by the U.S. and allies.
Additionally, while the U.S. will support Israel against attacks, the current administration is unlikely to support Israel in a major offensive action against Iran, including attacks on Iranian nuclear facilities and attacks on Iran’s oil and gas infrastructure, especially with the presidential election on the horizon. Furthermore, such an aggressive move cannot be taken without considering the response from other countries, including China, which is a supporter of Iran and the most significant buyer of Iranian crude oil.
Without U.S. support, Israel will find it difficult to carry out these types of attacks with access to only fighter jets, which do not have the necessary range to reach the required targets. Therefore, we think the probability of major conflict between Israel and Iran is much lower than reflected by the initial price spike, and therefore, unlikely that there will be any material interruption to the flow of oil.
The risk of such an interruption, however, is higher now than before the Iranian attack, which translates into a non-trivial risk premium, which was not the case prior to the Iranian attack, when the risk premium had essentially disappeared.