Why can't oil prices collapse in the short term?

"The current situation of the mismatch between supply and demand is almost unsolvable
.

As the only sector in the S&P 500 to rise this year, energy-related topics have been extremely hot
.

In ten days, international oil prices have plummeted twice in a row, the most recent being the 22nd, when oil prices fell by 8%
at one point.
On the 23rd and 24th, Brent oil prices and WTI oil prices stabilized at around
$110/b and $105/bbl, respectively.
From the current price point of view, although there is a 10% decline compared to the previous high, it is difficult to alleviate the current inflation
.

Strictly speaking, we believe that the current oil price is not out of the upward cycle, and the main reason for this round of plunge is that after Fed Chairman Powell warned that the US economy may be in recession, the market's concern about the subsequent economic trend broke out
.

Fundamentally, the following set of data may indicate that there has been little change in
the fundamentals currently supporting oil prices.

Source: Barchart website

As can be seen from the chart above, the current futures market maintains the previous Backwardation structure, that is, the price of the near-term month contract is higher than the price of the forward month contract, and the spread is maintained at about $2-3 / barrel (the normal situation is within $1 / barrel), which is also a very high level
in history.
Such a structure suggests that the demand side needs to pay higher costs for more recent crude oil, which means that the current demand for crude oil is still much larger than supply and will continue for a long time
.

We have always believed that for commodities like oil, supply and demand will always be the first factor
affecting oil prices.
On the demand side, there is no direct data to prove that we have entered a recession cycle, and from the perspective of crude oil demand, global demand is continuing to recover; On the supply side, after Europe announced a complete ban on the import of Russian crude oil from the sea, it is very difficult
to find new supply growth points.

While we are also looking forward to a more reasonable oil price, which is good for all countries and industries, it is completely unrealistic
to say that crude oil will turn downward now.
Our judgment is based on two basic facts: the global idle capacity is basically at the top, and the control capacity of Western governments led by the United States has also bottomed out
.

01 No spare capacity found

Demand for crude oil has risen so fast this year that current supply looks stretched
.

In our view, until December 2022, the key to observing supply indicators remains at OPEC+
.
Since the organization will maintain quota production until December this year, Saudi Arabia and Russia still have a lot of initiative, directly affecting crude oil production
throughout the second half of the year.

It is worth noting that even for these producing countries, the current oil price of around $110 per barrel is already too expensive, and such oil prices will force central banks around the world to consider raising interest rates to deal with inflation
.
Expectations of a recession based on high inflation will weigh on crude oil demand, and the blow to oil prices will be huge
in the event of a sustained sell-off in crude oil futures contracts.

Therefore, we suspect that unless global economic conditions deteriorate very significantly over the next two months, or China's core metropolitan area once again enters its previous lockdown, OPEC+'s internal view will still favor increasing production to calm the current excessively high oil prices
.

But OPEC+ production growth is already near its peak, and no one can extract oil
that doesn't yet exist.

Over the past two years, the low or even negative interest rate strategies of central banks around the world have increased their support for the economy, but for OPEC+, which plays the role of the oil market "savior" in the global economy, they are running out of spare capacity
for crude oil.

Since the beginning of 2021, OPEC+ has been adopting a "gradual increase in production" strategy, and the organization's production has been in a state of
gradual increase.
Even due to the impact of this year's events in Russia and Ukraine, production has not dropped much
since April.

Source: S&P Global Platts

On June 30, 2022, OPEC+ will hold an upcoming meeting to approve a new monthly production increase plan
.
Theoretically, the new production ramp plan would restore crude oil production to pre-COVID-19 levels; But in reality, limited by sanctions against Russia and the lack of production increases in recent months in countries such as Nigeria and Libya, the increase in capacity may fall far short of expectations
.

According to S&P Global Platts, Saudi Arabia, the organization's largest producer, reached 10.
45 million bpd in May, just over 500,000 bpd from its peak capacity of 11 million bpd
.
In addition to Saudi Arabia, the United Arab Emirates, another country with spare capacity, is similar
.

In theory, Saudi Arabia and the United Arab Emirates still have a combined spare capacity of nearly 2 million bpd, which is most likely all that OPEC+ can provide for the second half of the
year.
However, we see the current state of the market and have a lot of skepticism about this number, otherwise there would be no structure
of spot premiums.
What really matters is not how much of the actual remaining capacity is, but how much of the market thinks there is
.

The situation in the United States is also not optimistic
.
After the collapse in oil prices in early 2020, many U.
S.
oil companies have changed their business strategies, preferring to distribute the money they earn to investors rather than to invest in expansion
.

What is even more regrettable is that at present, we do not see any immediate action of the US government in controlling oil prices, neither encouraging upstream miners to increase investment and expansion, nor effective means to stimulate refiners to invest in the construction of new plants
.

02 Donkey skills are poor: the means to cope with high oil prices are insufficient

Just on June 15, U.
S.
President Joe Biden sent a letter to seven oil companies, Marathon, Valero, Philip 66, Chevron, BP, Shell and ExxonMobil, asking them to increase their refining capacity, increase oil supplies, and ensure U.
S.
energy security
in the short term.

The day after the news was issued, oil prices fell sharply, and many media attributed the decline in oil prices to the letter
.
However, we believe that this is precisely the approach taken by the Biden administration in the face of near-desperation, and there is little way to produce any practical effect
.

Since 2019, the control of carbon emissions in developed countries has caused many old refineries built in these countries to close; At the same time, no one will invest in new refineries due to misestimation of peak energy consumption and harsh environmental policies, resulting in a 45 million tonnes/year decline in refining capacity outside of China in 2021, a record
since 1988.

Therefore, the current refining profit margin hit a record high, especially the profit of diesel, more than $50 / barrel, if there is no government restrictions, no refining company will resist such a temptation, even if the existing refining capacity is insufficient, will invest in new facilities to strive to eat such dividends
.

Source: ExxonMobil website

ExxonMobil's response to the letter can be seen to some extent the current embarrassment of the
United States.
In the short term, they recommend that the U.
S.
abandon some of the provisions of the Jones Act and some fuel specifications to increase supply; In the long run, the United States needs clear policies to promote investment and support domestic resource development, such as simplifying regulatory approvals and strengthening pipeline construction
.

So far, apart from some medium- to long-term incentives, no company has announced that it will flatten prices
by boosting production.

To be honest, on the eve of the November election, Biden is not without an immediate solution
.
China currently has the world's largest refining capacity, and the comprehensive refining plant operating rate is not high, if Biden trades some chips to show favor to China, so that more Chinese refined oil products into the global market, I believe it will have a very good effect
on the current soaring oil prices.

Of course, a better approach would be to persuade Europe to abandon sanctions against Russia, at least oil prices can fall by another $30 / barrel, and there is no need to raise interest rates at this measure
.
However, whether it is to show favor to China or to abandon sanctions against Russia, presumably the Biden administration will not adopt it
.
As the election approaches, the situation of this US administration can only be described
as "cocooning itself.
"

Without improved supply and effective government control, it will be difficult for the crude oil market to return to true balance and health
.

So far, the rise in oil prices from the end of 2021 to the beginning of 2022 is almost a copy of the 2007-2008 period, and the price trend is almost completely synchronized
.
However, we believe that any idea that the oil market will repeat the mistakes of 14 years ago is unrealistic
.
The subsequent market we believe is more like the 2011-2014 period, although there is no high above $140/bbl, but there have been more than 40 consecutive months above $100/bbl
.

Data source: Bloomberg The black line is the current oil price trend, and the blue line is the oil price trend from 2007 to 2008

As of now, the average price of Brent crude oil in 2022 has exceeded $100 / barrel, and there is still a possibility
of rising in the second half of the year.
But how long crude oil prices can continue to rise, I am afraid there is no sign
of an end.