- A shortage in energy supply, including natural gas, has lifted oil prices higher.
- Oil has overshot our fair value estimate of $69 a barrel due to demand expectations.
- Conditions in physical markets are stable and refineries have capacity.
Oil prices have rallied to multiyear highs on surging demand, tight supply, and the crunch on natural gas. Brent crude futures, the benchmark in global energy markets, hit a three-year high of above $86 a barrel in late October. Futures for West Texas Intermediate (WTI), the U.S. benchmark, surpassed $85 a barrel, the highest since October 2014. We analyze the dynamics of the crude market below.
A volatile market
The key question is whether the rally in oil prices can be sustained. Rising natural gas prices and a cold winter could lead to a further increase in prices. However, this rally has extended beyond market fundamentals. Oil markets are historically volatile, and should crude overshoot current levels, a correction would likely be sharp. From a trading perspective, this isn’t the right time or price to take long positions, in our view. That is partly because many sell-side commodity traders are revising their forecast to $100 a barrel, while physical markets aren’t showing a level of tightness consistent with that.
It’s true that in the United States, inventories of crude and petroleum products have fallen below the five-year average. This indicator, however, is misleading due to the jump in inventories during the Covid-19 pandemic. It is fair to say that inventory levels are now close to those of late 2018 and early 2019. During that period, oil prices were volatile, between $40–$70 a barrel.
Our fair value model for oil shows $69 a barrel for WTI. But prices have already overshot this level, showing the steepest increase since we started our fair value analysis. In our view, for oil to continue to trade at more than $80 a barrel, inventories will need to decline in January and February — the seasonally weakest months of the year. If inventories do not decline during this winter, we believe prices of WTI in the futures market will likely converge to our fair value to reflect existing supply-demand conditions.
U.S. crude has surpassed the fair value estimate
(US$ per barrel, daily)
Sources: Bloomberg, Putnam Investments calculations, as of October 31, 2021.
Demand and supply dynamics
Why are prices overshooting? We believe it is because of concerns about shortages as the northern hemisphere heads into winter. It has little to do with oil’s physical markets. Prices of other energy sources, natural gas, and coal, have spiked due to low inventories, rising demand from China, and worries about a cold winter. The surge in global natural gas and coal prices has also lifted oil futures, partly because of expectations about rising demand for cheaper oil. There are also supply shortages for light, sweet crude in Europe.
Demand for light, sweet crude is high because of refinery dynamics, including its lower refining cost. Refineries are heavy users of energy. Complex and profitable refineries process high sulfur oil (cheaper oil) at hydrocrackers that use hydrogen generated from natural gas. Higher gas prices in Europe and Asia have raised the operational cost of these hydrocrackers. As a result, crude inventories remain low in Cushing, Oklahoma, a storage hub and delivery point for the NYMEX WTI futures contract, while more barrels are being diverted to fill the new Capline pipeline in Illinois. These dynamics have contributed to the low price spread between Brent and WTI crude.
Demand, however, remains low for heavier, sour crude. There are still unsold barrels of this oil in the Middle East, including the Upper Zakum grade crude from the United Arab Emirates. West African grades are also having a tough time as freight costs increase. In addition, China’s limited oil import quotas are having a troubling impact on oil from Angola.
The rally in the futures market has extended beyond the fundamentals of the physical markets, in our view. The Organization of Petroleum Exporting Countries and its partners (OPEC+), a 23-nation grouping led by Saudi Arabia and Russia, are sellers in the real market. They are more concerned about the physical market for oil versus the financial markets.
Predicting the future of the rally
A colder winter could send natural gas and coal prices soaring, and this could impact crude prices as companies and manufacturers further switch to using oil. However, because we rely on physical markets, and not necessarily the weather, to forecast the trend in oil markets, we believe it is time to question the current rally. We have a neutral view on oil prices over the short term and a bearish view over the long term.