Oil price declines mask improving fundamentals

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Oil stabilized on 16 August, following a fall of around 1% in the prior trading session. Brent crude prices stand at around USD 85/bbl, about 3% below the year-to-date highs reached on 9 August. We think the chief drivers for lower crude were underwhelming Chinese activity and credit data for July.

Some investors remain skeptical that China’s latest stimulus efforts—a 15-basis-point cut to its one-year medium-term lending facility (MLF) and a 10bps cut to the short-term 7-day reverse repo rate—will be sufficient to revive demand. China is the world’s largest oil importer, the second-largest consumer, and the seventh-largest producer.

But we do not expect recent price falls to persist, in light of the oil market’s firming fundamentals:

We expect global oil demand to hit a record high in August. Unlike in other commodities markets, we think global oil demand has never been healthier. Chinese demand has hit a record high this year, in spite of recent economic releases. Daily demand has tracked above the pre-pandemic average (2015–2019) in every month this year, according to International Energy Agency data. Appetite for gasoline, diesel, and jet fuel has been especially firm—reflecting a normalization in travel habits after pandemic-era restrictions. And we expect August demand to reach 103mn barrels per day (mbpd), a record high.

Oil inventories are declining, tightening the market. While OECD commercial stocks had been rising year-over-year as a result of oil releases from strategic inventories, we see signs that they may contract going forward. Oil inventories are starting to fall in some Asian countries like China, while waterborne oil stocks have also registered large drops in recent weeks. At the same time, Asian and European oil refineries are increasingly obliged to find alternative barrels from non-OPEC+ producers. And it is telling that data from tanker trackers suggest waterborne crude imports in China have been very strong so far in August, despite the recent weakness in growth indicators.

OPEC+ production is near a two-year low and supply looks set to stay tight. OPEC+ has instigated voluntary production cuts since May in order to tighten oil markets. Saudi Arabia then further reduced output, meaning the group’s production and exports are declining. And with Saudi Arabia and Russia extending their production curbs into September, we expect global oil markets to be undersupplied by around 2mbpd in August and by more than 1.5mbpd in September. Investors have accounted for this tightness in futures markets, with the difference between high near-term contract pricings and lower-priced contracts further out deepening (a downward-sloping curve is known as “backwardation”).

So, we still see scope for global oil prices to rally. We now expect Brent to hit USD 95/bbl and the US WTI benchmark to rise to USD 91/bbl by end-December, up from the current USD 90/bbl and USD 85/bbl, respectively. We hold a most preferred view on oil in our global strategy. Risk-taking investors can consider adding long exposure via first-generation indexes or longer-dated Brent contracts, or selling Brent’s downside price risks. And for investors looking to gain exposure to oil trends through equity markets, we hold a most preferred view on US energy equities. The sector (S&P 500 Energy Index) has underperformed the S&P 500 Index by around 16 percentage points this year despite solid earnings prospects and appealing valuations, with forward free cash flow yields of around 11% looking especially appealing to us.