What has pushed down the Brent Crude Oil price to $71/bbl?

20 Mar 2023 , 09:37 AM

Most of India’s crude has been historically priced at Brent prices. India is especially vulnerable to the global price of crude for two reasons. Firstly, it is the third largest consumer of crude oil after the US and China. Secondly, India relies on imports for nearly 85% of its daily crude oil needs. This makes the Indian economy especially vulnerable to the movements in crude prices.

Why this bearishness in crude oil prices?

There is something strangely bearish about oil in the month of March 2023. Oil had a major rally in the first half of 2022 as the Russian war in Ukraine intensified. Brent Crude touched a high of $120/bbl, but had gradually tapered from these levels on global economic slowdown fears. However, between March 06th and March 16th 2023, the price of Brent crude fell from $86.2/bbl to $71.9/bbl. That is a 16.6% fall in Brent Crude prices in just about 8 trading sessions. During the same period, the US benchmark West Texas Intermediate (WTI) crude also fell from Rs80.5/bbl to Rs66.3/bbl, a fall of 17.6%. What explains so much bearishness on oil prices.

Clearly, a fall of 16-17% in crude oil prices in a span of 8 trading session is far from normal, especially when there are no likely disruptions visible on the supply side. Effectively, oil prices have fallen to their lowest levels in 15 months and the immediate trigger appears to be what is happening to the banking sector globally and the likely fallout on the demand for crude oil. But, according to oil market traders, it is not just about the fear of a slowdown. It is also reflective of the speculative long positions that were built up ahead of the banking crisis. Most these long speculative positions have since been unwinding. 

Banking crisis and the impact on oil prices

The banking crisis has not only developed but also exacerbated in the last couple of weeks. It began with the implosion of SVB Financial Bank a week ago. In the next few days, Silvergate Capital went bust, Signature Bank had to wind up and First Republic Bank was on the brink. It was the $30 billion deposit from JP Morgan and Morgan Stanley that saved First Republic Bank from an implosion, but the crisis is far from over. There are apprehensions that a large number of small niche and regional banks in the US may be in some serious problems. It is a mix of slowdown fears, liquidity slowdown and rising interest rates.

The contagion has quickly spread to Europe and India is already calculating its total exposure to SVB and other banks. But the bigger worry is the rising concerns over Credit Suisse. This is not just any other bank, but one of the largest banks in Europe and with the potential to create systemic risks for the markets. The stock price fell to an all-time low even as its credit default spreads touched a new high. Now the fear is that the banking crisis combined with hawkish central banks could have a negative impact on demand and that is hitting the price of oil. After all, the US banks along are sitting on potential bond losses of $750 billion due to persistent rise in yields. If you add similar losses for European and other banks, the overall figure could be well in excess of $2 trillion. So, the demand front is going to be anything but easy.

Unwinding of speculative oil trades

While banking crisis and slowdown fears were the broad themes, the immediate trigger came from a different side altogether. The fall was led by aggressive unwinding of oil long positions by hedge funds. The unease in the financial sector was spilling over to the energy sector, which happens to be extremely demand intensive and price sensitive. Most oil traders were concerned that the banking crisis could impair the economic outlook for most economies and that would spill over into energy demand and energy prices. That would obviously translate into a sharp fall in oil prices. In any sell-off, it is the typical “winner take it all” story. The traders who get the first exits, gain the most. But the bigger question is where had the enthusiasm to buy oil futures come in the first place.

In a sense, the optimism had come in the aftermath of China abandoning its zero-COVID policy and committing itself to higher growth. There were expectations that China would be able to show good growth of around 5% in the coming years. That may be lower than India, but on a GDP base of $15 trillion, that is a substantial accretion to the GDP pool in absolute terms. That is what most of the speculators on oil were betting on. In the last 2 months since the announcement by China, there has been little evidence of growth returning to China in a big way. That was already a dampener for the long position holders. To add to their worries, the banking crisis only enhanced concerns that the presumed demand boost for oil may not happen at all. That led to heavy speculative unwinding of oil longs.

Is demand falling faster than supply?

That is the billion dollar question that is now being asked in oil trading circles. The OPEC has been trying to cut supply to match falling demand, but the fall in demand appears to be happening at a faster pace than expected. That is evident in the rising inventories of oil in the last few weeks. Sample these. In its latest report, the International Energy Agency (IEA) has underlined that the oil stocks of wealthy countries had surged to an 18-month high in the month of January and had sustained it through February 2023. In short, it was a surprise for the markets as they had expected the supply to be much tighter. Instead, leading banks like Citigroup pointed out that oil markets were much looser than expected.

How relevant is Brent price really?

One question that is now being asked in markets is; how relevant is the Brent price? For the price to be representative, it should have a lot of physical purchases and sales that are benchmarked to it. The largest consumer, the US, benchmarks its crude to the WTI and not to Brent Crude. The second and third largest consumers of crude; China and India are heavily procuring oil from Russia. Ironically, Russia is under Western sanctions, but India and China have refused to take these sanctions seriously as long it impacts their long term oil security. Most of India’s crude purchases from Russia are at discounted prices, with little relation to the Brent prices. With India and China increasingly relying on bilateral oil agreements, there is a big question mark over the relevance of Brent as a benchmark.

The bigger question is, whether the oil price fall is done or there is more to go. While demand contraction is a risk, there is no fresh supply coming in. It is not like 2014, when shale changed the equations. Also, the US is likely to step in and buy oil to replenish its Strategic Petroleum Reserves (SPR), after it had to sell millions of barrels amidst rising crude prices. With WTI well below the target buying price of $70 for the US government, oil should find some support. For now, it is touch and go for oil.