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A correction or weakening demand?

Between Thursday May 30th and Monday June 3rd, Brent oil prices lost a whopping 12% in just three trading days. According to Morgan Stanley, a similar thing has happened only forty-eight times since the beginning of 1984 (in over 9,000 trading days).

A correction or weakening demand?

Twenty-nine of these slumps occurred during recession and the Asian financial crisis, and were spurred by weak demand. Another thirteen coincided with the 1986 oil price crisis, a remarkable period in the history of the oil market marked by a serious supply glut. There have been only six such sell-offs in ‘normal’ conditions over the past 35 years, with the most recent one recorded more than 15 years ago – in 2004. Even during the oil price collapse in 2014 and 2015, Brent oil never fell so steeply in just three days.

I prefer not to comment on short-term fluctuations in oil and fuel prices if they fall within an intuitive range of volatility around longer trends driven by fundamental factors. A month ago, I made an exception as the price of oil had touched the upper end of my subjective range of volatility and was expected to subsequently move down. So it did, and there would be nothing to write home about if it had not been for the surprising rate of the decline – USD 10 per barrel within a month, and USD 15 per barrel from a peak at the end of April.

What does this say about the oil market? Morgan Stanley analysts believe there are three possible explanations:

First, it could be an ordinary event in a ‘normal’ market environment. But given that only six of the previous forty-eight sell-offs were of such nature – and those forty-eight are in themselves extremely rare – this proposition is not an obvious starting point for analysis.

Secondly, it could all be down to oversupply. This also seems unlikely, though. The oil price rises were driven all along by factors restricting the supply from Iran, Venezuela and North Africa, as well as production cuts agreed between Saudi Arabia, Russia and other OPEC countries. An added factor was the declining output in Canada and Norway. According to IHS Markit’s estimates, since the beginning of the year these factors have wiped 2 millions of barrels per day of oil off the market. Ergo the current developments are not a rerun of 1986.

We are left with a proposition that demand is growing at a much slower pace than expected. Based on the most recent oil market and macroeconomic data, this seems ever more likely. Since estimates of global oil demand are available with a time lag, markets rely on fragmentary information to build expectations about trends in demand. In contrast to demand, which is quite inertial, such expectations may change virtually overnight on another piece of unfavourable news, and news undermining demand is all but scarce.

I will not exaggerate if I say that worsening relations between the US and China are a drag on global economic growth. The trade war between the two nations has entered a new and dangerous phase. Growing barriers to international trade, from tariffs to national security restrictions, are undermining mutual trust and resulting in more tariff barriers. A quick solution remains possible, as Presidents Donald Trump and Xi Jinping are meeting at the G20 summit next month. At this point, however, it seems more likely that the trade war will be long, chaotic and expensive. According to Bloomberg economists, if tariffs rise to cover all US-China trade and markets fall in response, the cost would be 600bn dollars of Gross World Product in 2021 (the year of the greatest impact). From today’s perspective, the US-China rivalry goes far beyond tariffs and trade surpluses, and both countries are becoming increasingly intransigent in their belief that abandoning cooperation is inevitable.

A source of uncertainty in international relations affecting global demand is the fact that the US policy towards its trading partners is now strongly liable to change. The recent warning that the Donald Trump administration would impose duties on Mexican imports, including oil, for non-trade reasons, is a recent example that standards in international trade as we know them no longer exist. Uncertainty regarding the ground rules of international trade and the deep rift in US-China relations pose a major threat that strong growth in global oil demand, which has been the key driver of oil price recovery since 2016, may be stifled.

Chinese demand is already showing signs of weakening. IHS Markit reports that in April this year, light vehicle sales in China fell 17% year on year, marking also the 10th consecutive month-on-month decline. In 2018, light vehicle sales in China fell for the first time since 2000, ending the era of their global growth. These concerns are not limited to China. The International Energy Agency’s data of May showed a year-on-year decline in consumption of crude oil and gasoline in the US, with the country’s oil inventories 32 mbd above the five-year average, partly due to higher US output.

What is next for oil prices? If Brent prices return to USD 70 per barrel, this will mean that concerns over global economic growth have eased, demand for oil remains strong (around 1.5–1.6 mbd), and the availability of supply is again a cause for worry. This was assumed in the base case scenario for the global oil market from a month ago. However, the cast in that scenario has changed. Now the leading role is played by China (demand) rather than the OPEC cartel.

Adam Czyżewski

Adam B. Czyżewski, Ph.D., has been the Chief Economist at PKN ORLEN since 2007. He specialises in the changes of the global energy sector that are driven by economic policies and revolutionary innovations.