Business

Is A Recession Really The Next Big Risk For Oil?

Crude oil is a notoriously inelastic commodity—whatever its price, consumption does not vary greatly. Yet per a notorious industry joke, the only cure for high oil prices is higher oil prices. And we seem to be nearing the point of demand destruction as oil-dependent economies begin to slow down in response to rising prices.

The first signs are emerging in fuel consumption and financial markets. A Wall Street Journal report from this week noted that US drivers are beginning to curb their gasoline consumption in response to prices that earlier this week reached a historic high, topping $5 per gallon before retreating a few cents.

The report cited a weekly survey of gasoline sales that showed these have been lagging behind year-ago levels for 14 weeks in a row, with sales for the first full week of this month down by 8.2 percent on the year-ago period.

The WSJ also cited analysts reporting that people were carpooling, filling their tanks with only as much gasoline as they needed immediately, canceling trips, or working from home more days of the week in a bid to reduce their fuel consumption.

This is not all, either. According to Reuters’ John Kemp, demand destruction is about to become pronounced in diesel fuel demand, too, as the Fed tries to rein in inflation with rate hikes, risking a recession.

Over the next 12 months, Kemp wrotediesel fuel consumption in the United States could decline by between 200,000 bpd and 600,000 bpd as a result of a slowdown in the economy, which, in turn, is a likely outcome of the Fed’s measures to counter rising prices across the board.

In a testimony to the Senate banking committee, Fed’s chair, Jerome Powell, said that a recession was “certainly a possibility”, as quoted by the Financial Times, explaining that putting a lid on prices while keeping the job market as robust as it is now would be a challenge.

“The question of whether we are able to accomplish that is going to depend to some extent on factors that we don’t control,” Powell said, citing the war in Ukraine, which has significantly contributed to the commodity rally, and China lockdowns, which have extended supply chain problems.

Indeed, signs of an economic slowdown are emerging in different parts of the world, signaling that the tide may be about to turn for oil. Factory activity data released this week for the US, the UK, Japan, and the eurozone all revealed a weakening, with Reuters noting that US producers booked the first month of lower new orders in the last two years.

The risk of a recession is certainly a strong bearish factor for oil prices and the prices of all commodities. The strong rally in commodities and oil specifically is an additional cause for concern: after all, sooner or later, all rallies end.

According to a Credit Suisse analyst, the signs are there that the rally is close to being over. Mandy Xu, speaking to Bloomberg, pointed to the options market and a gauge dubbed the put skew, which indicates that oil is running out of upward potential.

“Even the most supply constrained commodity such as oil, what we’ve started to see in the derivatives market is people starting to price in more downside risk,” Xu told Bloomberg, adding, “The only sector up on the year is energy, and that is what we’ve been highlighting for a couple of weeks now in terms of the next potential pain point for investors. “The risk of recession means that further upside in the sector is likely limited.”

Related: Europe Faces “Red Alert” For Gas Supply As Russia Reduces Flows

It may be a while yet, however, before inflation erodes demand enough for a sustained price decline, at least according to Goldman Sachs. In a note published this week, the investment bank’s analysts said supply remains below demand for oil and added that the Fed “cannot print commodities.”

Indeed, the International Energy Agency in its latest Oil Market Report, forecast oil demand surpassing pre-pandemic levels next year, reaching 101.6 million bpd. This demand, however, will not be driven by Europe or the US It will be driven by China and other non-OECD countries.

This would mean prices will remain elevated for the observable future, although further sharp rises may become less likely, unless an outage occurs, like the one that recently decimated Libya’s output.

As far as supply is concerned, the US and the EU are currently discussion letting more Russian oil reach international markets despite EU sanctions as the US fears the sanctions will drive oil prices further up.

An Iran nuclear deal could greatly improve the availability of oil on international markets, but it remains elusive. Iran said this week it remains “serious” about agreeing on the deal and called for “realism” from the United States so the two could reach “a good, strong and lasting agreement,” per Foreign Minister Hossein Amir-Abdollahian.

OPEC+ is not pumping more, this much has become clear, and non-OPEC+ producers cannot ramp up production fast enough to have any marked and lasting effect on prices.

So, it may be time to start preparing for the end of the oil price rally, but there’s no rush. No rush at all.

By Irina Slav for Oilprice.com

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