As Brent oil prices hit new highs of $135 a barrel back in April following Russia’s invasion of Ukraine and with every sell-side house talking about how we were due to run out of oil in the coming months and could see prices as high as $150 to $200 a barrel, oil prices since have collapsed 35% or so and oil-related equities are down 40% and more. With all the talk about energy transition and lack of inventories, why then are prices falling as opposed to rising as everyone had forecast?
Commodities are about demand as much as they are about supply. The latter is easy to forecast to an extent as production projects take time to plan and so the lead time is well-known. The former is the Achilles’ heel of many analysts purely because they assume demand is a constant and only keeps growing and never falls.
We all know the demand surge over the last year was not secular demand but an extraordinary, massive boost that resulted from the huge monetary and fiscal boost provided by central banks and governments across the globe to get the world out of the Covid collapse. Boosting that much liquidity in a system that has capacity constraints will produce price surges as companies and supply are not quick enough to meet that rising demand. It was as though the Fed lit a matchstick under a can of gasoline, no pun intended.
During this time, we had the Russian invasion where everyone assumed the sanctions would take Russian oil off the market. But India and China, driven only by price discounts, took up all that Russian crude, so it was just a matter of re-routing as opposed to a cessation of Russian oil altogether.
This market has been driven by liquidity since the 2008 crisis, the Fed’s Modern Monetary Theory experiment. Given the mess the Fed created with the massive inflation surge, with inflation averaging close to 9% year over year in June, this year the Fed had taken its foot off the liquidity pedal. Now global economies are crumbling as the data have been coming in disastrously weaker, with the economy running out of juice as inflation is just too high for the average consumer versus real wages tracking lower, unable to keep up.
Industries, consumers and businesses all over are suffering from the monster economy the Fed has created and demand has been falling. At a time when demand for all goods is falling, supply has been stable to rising, which means prices need to come down. This is the case in oil, too, as supply deficits once penciled in and euphoric assumptions of the world running out of oil are now being ratcheted back as the second-half inventory balance looks a lot more normal. Demand is never a constant and the sell side analyst, just like the Fed, really just pencils in what has happened, never able to take a view of what will or could happen. Therein is the problem as it really does not help the investor to invest in a timely manner, as these same clients are now nursing wounds of negative 40% after being sucked in by the bullish analyst calls.
The secular tightness in the oil market over the past few months came mostly from product availabilty. Russian exclusion of products and China refineries going into maintenance made matters worse. But that is now resolving itself as every refiner cranks up its units to churn out as much product as possible. It is all about timing, we just had a massive demand surge in a short period of time with a triple whammy of supply falling short.
Equities by definition are cheap as they discount future returns. Our mentors on the trading desk would always say cheap can always get cheaper. Perhaps a new slogan needs to be added to their repertoire: “Fundamentals follow price, not the other way around”.