Market developments have again brought political risk to the fore
Wholesale oil prices have started the new year in upbeat mood after coming sharply off the boil in the fourth quarter (4Q) of 2021. The market had come under serious pressure towards the end of the year, slumping to around USD 65 per-barrel in mid-December, weighed down by a number of factors. The widely-traded US West Texas Intermediate (WTI) grade fell from a 2021 peak of around USD 83 per-barrel in October, to just above USD 65 per-barrel in mid-November. A recovery materialised in late December, and the market is now showing an even more bullish attitude in early January, with WTI prices moving back up towards the USD 80 per-barrel mark.
Late in 2021, profit-taking (as big traders closed their “in-the-money” positions and booked gains for the year) was one likely reason for the softening of oil prices. Another was China’s apparent decision to draw upon its Strategic Petroleum Reserve (SPR), to lessen the impact of high oil prices. Beijing’s move took some wind out of the oil market’s sails, but of course this is the reason the SPR was established, to manage China’s exposure to oil supply or price volatility. Underlying Chinese demand is quite volatile, based on refinery activity, with weak throughput rates reported in 3Q 2021 of ca. 13.5m barrels per day (bpd) giving way to stronger reported levels of above 14m bpd in 4Q 2021. Indications in early 1Q 2022 suggest that Chinese imports may show a lacklustre trend, as the first tranche of authorised import quotas for non-state refiners (the so-called “teapot” plants) have reportedly been reduced. China may be planning to use the SPR again, a factor which could be influencing the setting of quotas.
Other features, such as the worldwide gas and LNG price spike of 3Q 2021, drove upward momentum in oil prices, due to the oil products’ status as a substitute fuel. The spike and its effects were partly corrected in 4Q 2021 as the gas crisis was to some extent dissipated. However, the bullish trend in gas and LNG markets has once again surfaced, as problems remain with the regulatory approval of the Nord Stream 2 gas pipeline from Russia to Europe. One bearish feature of 4Q 2021 was the absence of a cold snap in the Northern hemisphere, which usually drives demand for all forms of energy. This has continued into 2022, and the longer we have to wait for any effects of winter temperatures on oil demand, the weaker they are likely to be. Also bearish is the effect of the Omicron variant, which is undermining travel activity and therefore fuel demand.
Early trading patterns in 2022 suggest that the bullish forces are outweighing bearish sentiment, and political risk has also suddenly come back to the fore. The loose amalgamation of producers dubbed OPEC+ has reportedly experienced some difficulty in raising output to the levels permitted in the amended agreement. Problems related to the functionality of the oil export infrastructure in Nigeria, combined with a reported halt to oil production at Libya’s El Sharara oil field and pipeline repairs, appear to have curtailed OPEC+ efforts to raise oil production as quickly as intended. Saudi Arabia, in view of its role as swing producer in OPEC, may of course be able to solve any stubborn output problems. However, the crisis now emerging in Kazakhstan has suddenly reminded oil traders of the risk of political disruptions to oil supply. The former Soviet state produces around 1.6m barrels-per-day, not a substantially important rate, but it has a reputation for stability. Hence, while the civil protests this week have not interfered with Kazakhstan’s oil production so far, a nervous mood has clearly taken hold in markets.
Alongside volatile fundamentals, the oil market is grappling with a number of long-term structural issues. Oil was barely mentioned at COP26 in October/November 2021, where the main steps forward concerned deforestation, use of coal, and the pioneering concept of “Green Corridors” for shipping. But, while the oil industry escaped immediate action, question marks remain over the likely trend of fuels demand. Consumption from the air sector remains drastically diminished by the pandemic, while upbeat seaborne trade has supported bunker fuel prices. How the outlook for conventional fuels demand will be influenced by the use of LNG, ethanol and hydrogen in shipping and haulage, remains uncertain. Without a precise blueprint and timescale for the replacement of fuel oil, bunkers and other conventional oil products, by LNG and so on, it is not possible to rule out a significant role for oil in the long-term (beyond 2030).
Funding of oil production projects has also emerged as a key question. Notwithstanding the COP26 outcome, the decision has been taken by many banks in Europe and the US, usually under pressure from their shareholders, to hold back from funding new oil production projects. This trend has created a perception among some observers of a future shortage of oil, another source of support for oil prices even in the near-term. This question of how future drilling and exploration will be financed is taxing the minds of traders. And the likely solution which may emerge, based on observations from the US LNG market, where private equity and hedge funds are prominent, is that these market players could fill the gap. LNG projects take years to get off the ground, whereas oil projects can be monetised more quickly, suggesting that private equity and hedge funds, which are less susceptible to shareholder challenges and public scrutiny, may pursue attractive opportunities in the upstream oil sector.
Given the inevitable role of oil in the global energy complex in the medium-term, the future operations of oil companies are likely to include the concept of mitigation as an integral part of transition policies. This was touched upon at COP 26 and serves as an obvious short-term response through which oil companies can easily show commitment to the general aims of the conference. Mitigation may already be demonstrated by ongoing participation in renewable power and LNG projects. New approaches to mitigation may take the form of direct involvement or funding of reforestation projects, irrigation of areas affected by drought and fires, and investment in infrastructure to accommodate the supply of new fuels, such as hydrogen and ethanol. Moving through 2022, the concept of mitigation will become the watchword for oil companies everywhere, and will motivate much of their thinking.
Looking ahead in the trading market, wholesale WTI prices are likely to remain strong in the coming weeks. Despite ongoing pandemic-related restrictions, the rapid spread of the Omicron variant may mean that it also recedes quickly, whereby fuels demand can continue its underlying long-term recovery. Oil prices will also remain acutely sensitive to the higher political risks and volatility which are now emerging and are therefore prone to bullish reactions to any uncertainties related to the security of oil supply.
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