In the ever-changing world of crude oil trading, prices have seen another drop despite the heightened geopolitical tensions in the Middle East. This may seem counterintuitive, but when we examine the broader fundamentals of the oil market and adjust our risk premiums based on the evidence of the past year, it starts to make sense.
Taking a look at the global proxy crude benchmark, Brent, we can see that its price range over the past 52 weeks has been between $70.12 and $95.96 per barrel. However, the upper end of this range has barely been sustained. With only two short stints above $90, Brent has struggled to find support and remain elevated above this level, even with all the talk of $100 oil prices in the last quarter of 2023.
As of now, the front-month crude futures contract for April is trading at $78.03 per barrel. Additionally, all futures contracts six months out and beyond from the current front month are trading at least $1.50-$3 lower. This implies a state of backwardation, where the current price is higher than prices trading in the futures market further down the road. Essentially, traders are expecting oil prices to be lower later this year.
To determine the direction of oil prices, it is crucial to start with examining demand. Unfortunately, the outlook for the global economy in 2024 remains uncertain. Economic data from major powerhouses like China and Germany continues to disappoint. Additionally, major economies are still operating in a high interest rate environment, though some relief may come in the second half of the year. These factors contribute to the belief that demand will remain subdued in 2024, with the International Energy Agency projecting global demand growth of around 1.1 million barrels per day (bpd). However, the Organization of Petroleum Exporting Countries (OPEC) has a more optimistic projection of 2.25 million bpd.
Regardless of which demand forecast one chooses to believe, it is important to consider the supply side of the equation. Both higher and lower projections can be met by non-OPEC supply growth alone in 2024. The market is currently oversupplied, with the United States taking the lead as the world's largest crude oil producer in 2023, pumping over 13 million bpd. Other non-OPEC countries such as Brazil, Canada, Guyana, and Norway are also experiencing record production increases. This surplus, coupled with higher inventories and China and India's continued purchase of Russian oil despite Western sanctions, has led to an imbalance in the market.
It is often said that geopolitical risks fail to prop up oil prices to the extent they used to. However, this statement is not entirely accurate. There is still a risk premium in the market, but it is not working in the way many expect. The current decade of oil trading is vastly different from the last one, with major crude consumers like the United States, China, India, Japan, and South Korea diversifying their supply sources more than ever before. The United States, in particular, is both increasing its domestic production and exporting crude. These consumers are also seeing shifts in their demand patterns due to efficiency improvements and the rise of electric vehicles. This implies that oil producers will increasingly rely on petrochemicals and aviation as key demand drivers in the medium-term.
In light of this changing demand dynamic and the oversupply in the market, oil futures appear to be overbought and trading above their fair value. Much of this can be attributed to the re-calibrated risk premium, which is currently causing only a modest increase in prices. Even in the hypothetical scenario of a significant disruption to Iranian production, which would remove roughly 3 million bpd from the global supply pool, the impact would be less severe than in the past. The current market conditions and shifted supply-demand balance would likely result in a single-digit uptick in prices, rather than a double-digit one.
Considering all these factors, it is reasonable to believe that Brent's fair value for 2024 lies towards or at the lower end of a $70-$85 range. Of course, an improvement in the risk picture later this year or in 2025 could potentially lead to even lower prices.
It is essential to note that the views expressed in this commentary are the author's personal opinions and analysis. They are not intended as solicitation, recommendation, or investment advice regarding oil and gas stocks, futures, options, or products. The oil and gas industry, as well as equity markets, can be highly volatile, and opinions within the sector may change rapidly and without notice.
