The Unsettled State of Oil Markets

This fall, markets for crude oil and its products have found themselves mired in extraordinarily strong crosscurrents, from cuts to production from major producers to uncertainty over global demand that have had a push-pull effect on prices and market volatility.

Some of the factors at play in the oil market include:

• Inventories of gasoline and ultra-low sulfur diesel (ULSD) are at exceptionally low levels, at least in the U.S. While crude oil inventory levels are at somewhat more typical levels, the overall crude oil and products inventory situation shows potentially tight supplies heading into winter (Figure 1).
• On October 5, OPEC+ announced that it would cut production by two million barrels per day, the equivalent of approximately 2% of global crude oil output.
• The U.S. replied to the production cut by extending its drawdown of the Strategic Petroleum Reserve, which has already been reduced by nearly more than a third from its previous levels (Figure 2). In the short run, this contributes an additional 1 million barrels per day of crude to the market, but the drawdown cannot be sustained indefinitely.
• The global economy is slowing amid the most rapid pace of monetary policy tightening in the U.S. and Europe in decades to beat back the surge in inflation. Many other nations, including Australia, Brazil, Canada and Mexico, have seen much tighter monetary policy.
• China’s economy remains beset with COVID lockdowns and a faltering property sector, both of which are eating into its once fast-growing demand for crude oil and its products.
• The Russo-Ukrainian war continues to generate widespread uncertainty across commodity markets, impacting both the supply and demand equations.

Figure 1: U.S. crude oil inventories are low for this time of year

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Figure 2: U.S. strategic reserves are at their lowest in nearly 40 years

Amid these various developments, the oil market has shown little in the way of a consistent trend. In the days after OPEC’s announcement WTI prices for December delivery rose from $86 to $92 per barrel, and have held to their highs since. Yet, prices remain about 25% below their trading session closing peak of $120 set in late June.

In addition to the relatively mild moves in prices in October, the futures curves for WTI, gasoline and ULSD remain in sharp backwardation, suggesting that on balance traders see a greater risk of falling spot prices over the next two years despite OPEC’s production cuts and the currently low level of inventories. This suggests that traders are more concerned about slowing economic activity around the world than they are about supply shortages (Figure 3).

Figure 3: Investors price a decline in spot prices over the next two years as the most likely scenario

That said, options traders don’t appear to be overly confident about the market’s central scenario of potentially lower prices ahead. CME Group’s CVOL, a comprehensive view of implied volatility on futures and options, shows that options on WTI, gasoline and ULSD are relatively expensive compared to most recent historical periods. For the past few months, implied volatility on options has been hovering at around 50% or slightly above for these three products, which is roughly twice its pre-pandemic levels (Figure 4).

Figure 4: Though far off its 2020 highs, CVOL for oil products remains 2x its pre-pandemic levels

Moreover, the skew on options volatility has begun to tilt upwards. This suggests that while traders see declines in prices as being the most likely scenario, there is a greater risk of extreme upside than extreme downside (Figure 5).

Figure 5: CVOL option skew suggest more risk of extreme upside to prices than extreme downside

The upside risks to oil include any potential supply disruptions, including the conflict between Russia and Ukraine. Another upside risk could occur if China suddenly lifted its restrictive COVID policies, although recent statements from Beijing suggest that this is unlikely in the short term.

Downside risks come from a greater variety of sources. One is increased U.S. production. Despite the strong rebound in prices since the 2020 lows, U.S. production remains below its pre-pandemic peak of 13.1 million barrels per day (bpd). In late 2020 and early 2021, U.S. production ranged between 10 and 11 million bpd. It has since rebounded to 12 million bpd, but has shown difficulty in rising above that level (Figure 6).

Figure 6: The recent period of high oil prices has only fueled a modest recovery in U.S. production

U.S. production has only been growing in one region: the Permian basin. The other major fracking regions, Bakken, Eagle Ford and Niobrara, have seen largely stagnant production since 2014. Permian has seen soaring production owing in large part to pipelines that connect the region both to storage facilities in Cushing, Oklahoma and to export terminal near Houston, Texas (Figure 7). If oil prices were to rise further and remain high, it could eventually incentivize similar growth in other production regions but OPEC+’s efforts to stabilize the market have not pushed prices higher to that extent.

Figure 7: Oil production has been rising in the Permian but not elsewhere

Meanwhile, product markets remain unsettled, too. Given the extremely tight inventories and difficulties at refineries, the gap between crude oil prices and ULSD remains exceptionally wide (Figure 8). Markets price that diesel prices are likely to normalize as refinery issues are resolved.

Figure 8: Diesel remains in short supply in the U.S.

Slowing growth in China and a strong dollar a major concern

As the top importer of oil, China’s slowing economy is a major concern. Growth in China has been volatile and not very strong. The economy grew by 4.8% in the first quarter, 0.4% in the second, and 3.9% from July through September. Pre-pandemic China had been turning in growth rates of 6.5-7.0%. A major concern is the country’s Covid-Zero policy that has seen major cities being placed under lockdowns, hurting businesses and limiting consumer spending. Oil imports in September were down 2% from a year ago due to tepid demand amid the Covid restrictions.

The Chinese yuan has slumped to the lowest level in more than a decade against the U.S. dollar, crossing the psychologically import seven-yuan-to-a-dollar level, trading at 7.34 yuan to the dollar as of this writing. The dollar’s surge around 20-year highs against a basket of currencies including the euro could be another factor to dampen global oil demand. Most commodities, including oil, are priced in dollar and a stronger dollar tends to dampen commodity prices. Imports costs are expected to add up in oil-importing countries just from the exchange rate mechanism. Central to the dollar’s strength has been the Fed’s interest rate hikes to battle inflation. The Fed has shown no sign of slowing its pace of tightening, just as other central banks like the European Central Bank. If the dollar peaks soon, this could prove bullish for oil prices, at least at the margin.

Bottom Line:

• Options traders see an extreme upside more likely than an extreme downside
• Slowing Chinese economy could be a drag on oil demand
• Higher interest rates, strong dollar could also dampen demand for oil
• U.S. gasoline, ULSD inventories are low for this time of year