Oil: Bulls will have to wait!

6 Jul 2023 , 10:29 AM

During the webinar hosted by IIFL, independent oil consultant Vandana Hari shared that oil prices will remain weak (US$70- 75/bbl), and may collapse if demand outlook worsens. As of now, the market is well supplied. However, it has limited ability to enforce supply cuts, given already under-production by several OPEC+ members relative to their quota and Russia’s focus to generate revenues. Weak demand will weigh heavy on product prices and GRMs. Analysts of IIFL Capital Services think that weak oil bodes well for India, particularly OMCs, which are set to report record-high earnings in Q1FY24 and FY24; their valuations are also inexpensive (BUY).

i. Fears of supply disruption behind: While EU sanctions on Russian oil imports have kicked in, the market has remained well supplied. This is because China and India purchased the majority of Russian oil, instead of relying on their traditional sources; which has helped balance demand-supply equation to a great extent. Thus oil prices that were reflecting extreme risk of supply disruption, have corrected by almost 44% from their peak seen in March-2022.

ii. Oil demand growth may remain weak: Accounting for 46% of global Oil consumption, OECD countries have yet not seen material pickup in demand. Even in case of USA, consumption of transportation fuels accounting for ~70% of the overall oil demand, is actually down 5-6% from the pre-Covid levels. As for China, actual demand revival has lagged the initial expectations. However, Indian demand (5% global share) has continued to grow. If the economic outlook as seen by IMF, World Bank, etc., for developing nations plays out, their oil consumption may not grow at all in the foreseeable future. On this backdrop, the forecasts of IEA, EIA and OPEC, which unanimously project 2-3% growth in oil consumption, may seem hopeful. Pace of SPR refill by Biden administration in the USA has also lagged the expectations (only 3.2 mn bbl refilled and 9mn bbl likely in next 6 months). Thus, softness in oil price is more a reflection of demand weakness, as opposed to consistent bullish forecasts.

iii. Ex-Saudi, OPEC has no appetite to cut: Saudi Arabia has unilaterally cut oil production by 1mbpd and may extend cuts further to support the prices. The organisation may even call for other OPEC members to support its actions. However, actual production from some of the OPEC members (eg: Iraq, Nigeria, Angola, etc.) is well below their allocated quotas; any further cuts may not work out. Meanwhile, on the back of political diplomacy, Iran-Arab, US-Iran, Saudi-Yemen conflicts have abated. Libyan truce has held up, while militancy in Nigeria has subsided. On this backdrop, the risk of any adverse supply shock seems low.

iv. But, US also no longer a swing producer: While OPEC+ may not have a great ability to cut production, USA — which traditionally has been a swing producer — may not ramp up production either. This is because shale output from non-Permian basins is stagnant, and even Permian basin is approaching the peak. As such, producers are focussing on financial discipline and rewarding shareholders vs capex and production ramp-up.

v. Bears outweigh Bulls: Oil prices will remain range-bound between US$70-75/bbl for the next couple of quarters. Such an outlook neither considers weakness in developed nations, nor assumes an end to Russia-Ukraine war anytime soon. If such a scenario plays out, there is good scope for oil price to fall well below US$65/bbl; runaway increase in prices is likely when demand surprises and supply lags. This is certainly not on the horizon, given the above discussed issues. 

vi. Russian oil – discount narrowing: Urals have traded at US$28- 29/bbl discount to Brent since the war began in Feb-2022. For a typical Indian refiner, adjusting for freight charges, the landed prices were earlier nearly US$13-15/bbl lower vs Brent. However, such discount has narrowed down to only US$9-10/bbl now given the supply cuts from Saudi and sustained demand pull. Nevertheless, Indian refiners will continue to enjoy the discounted prices.