Although Oil Market may seem a distant issue, its price has a greater impact on our lives than what we think. Many economic activities depend on oil, from the gas that runs our cars to the operation of the industrial sector. Therefore, understanding the forces that shape its price is of crucial importance to make a proper analysis on how oil price fluctuations affect the financial world.
Who Is Who in the Oil Market?
Just like in any market, forces of supply and demand establish the price of oil. However, according to a report published by the U.S. Energy Information Administration last July, the total oil production reached 88.72 million barrels per day (mbd), while the total oil consumption amounted to 93.42 million barrels per day. The excess of demand over supply caused a decrease in inventories, keeping prices high. It must be mentioned, though, that the oil market does not follow a definite trend, fluctuating between excess supply and excess demand, accumulating or diminishing inventories as needed.
To analyze the oil market, the first step is defining who are the most relevant players to understand how their interactions and decisions shape the price of crude oil. Chart 1 displays both sides with the six major consuming and producing countries.
World production July 2020 World Consumption July 2020
Chart 1. Elaboration: Gandini Análisis. Data: U.S. Energy Information Administration
One of the distinctive features of the oil market is that the largest producer is the Organization of Petroleum Exporting Countries (OPEC). OPEC is a group of thirteen countries that make up what in economics is known as a cartel, among which Saudi Arabia, Iraq, the United Arab Emirates, and Iran stand out as the top producers.
However, the strength of this group to control the supply of crude oil has gone through a transformation since 2014. That year, oil prices went down because of the large-scale implementation of fracking in the United States, making the U.S. the second largest world producer with a market participation of 19.63%. This new dynamic, along with the return of Iran to the international market -following the supervision agreement reached by the Obama administration to prevent the enrichment of uranium in that country-, resulted in an excess supply that caused the Brent benchmark price to drop from $115 to $27 per barrel between 2014 and 2016.
This excess production became a driving and structural force in the oil market. OPEC cut down its production but, having around 30% of the world supply under its control, the cut down was not a determining factor. To revert the situation, OPEC entered into an agreement with other oil-producing countries, such as Russia and Mexico, known as OPEC Plus. In 2018, the group carried on the first of several cut downs on their production to artificially increase the price of oil, which surpassed $80 per barrel.
After the historical context of the oil market is understood, how these forces have been subject to the disruptive effects of the pandemic becomes clear. Chart 2 displayed below shows the behavior of two important crude oil references during last year: the North Sea Brent, mainly traded in London, and the WTI or West Texas Intermediate, traded in the U.S.
Chart 2. Elaboration: Gandini Análisis. Data: Bloomberg
The first fact that stands out is the negative price of -$37.63 for the WTI on April 23, a historical milestone in the oil market caused by a combination of supply and demand factors.
What happened in April dates back to January, when Covid-19 cases in China increased, and different economic sectors were shut down because of sanitary reasons. This had an impact on the demand for crude oil, since, as shown in Chart 1, this country is the second major consumer and the fifth major producer, which makes China a net importer.
As the virus spread to different countries, there was an excess supply of up to 9.47 million barrels a day last March. The price war that broke out that month between Russia and Saudi Arabia, the two major forces behind the OPEC Plus cut agreements, also contributed to the excess supply.
The conflict arose when Russia implemented a strategy that involved their exit from the OPEC Plus cut agreements to flood the oil market. The intention was causing a drop in the price that would affect the U.S. Shale Oil industry. Saudi Arabia responded by increasing its production. These events, combined with the decline in the demand triggered by the increasing number of countries that were forced by the pandemic to shut down economic sectors, led to an excess supply of up to 19.62 million barrels per day last April.
And the situation got even more complex. The storage capacity that had been filling up since January reached maximum levels for the WTI benchmark. With April 23 as the negotiation deadline for futures contracts that expired in April and a shortage in the storage capacity, investors who did not want to keep the crude were forced to pay to sell their barrels, resulting in a negative price.
It should be noted that, even though Brent prices did not reach negative levels due to greater storage capacity, they were affected by the global excess supply, falling to an all-time low of $19.99.
The market forces are correcting this trend, with the current plans to reopen economies and the subsequent demand increase. OPEC Plus made a historical production cut, of 9.7 first, and then to 7.7 million barrels per day, that brought up Brent to levels of $45.
However, several questions remain unanswered. Will reopenings last? Could new waves of the virus lead to reverse them, causing the demand to fall once again? For how long will producers be able to maintain high cuts at the expense of an income reduction? These are the issues to pay attention to in the forthcoming months to achieve a better understanding of the future course of the oil market.
Report elaborated by Gandini Análisis for SupraBrokers only as content. It shall in no case be considered as an investment recommendation.