Oil: Possible Global Recession And Its Effect On Demand Is Key

The WTI and Brent benchmarks fell below the $100 mark in trading on July 6 and 7 after significant declines on July 5, when Brent dropped 9% and WTI dropped 8%.

The question is whether prices will continue to drop.

1. Fears of a recession

The overriding cause of this week's decline in oil prices is global recession fears. It is possible that we might already be in a recession, and we won’t know it until certain data are released. However, the economic indicators for some of the world’s largest economies are not positive.

For example, Germany is looking at restricting manufacturing output due to a lack of natural gas. High energy prices across the world, but especially in Europe and the U.S., are causing consumers to restrict consumption. Even though travel is very strong at the moment, due to pent-up demand from the coronavirus restrictions, the fear is that consumers will be much more cautious about traveling with high prices once the summer is over.

Tuesday’s significant decline was assisted by a report from Citibank forecasting $65 per barrel oil by the end of the year if a global recession takes hold. If we do enter recession territory by the end of the summer and demand for oil drops by more than is seasonally customary, we could see an end to bull market. A recession and resulting drop in demand would be the greatest driver of lower oil prices.

2. High demand for Russian oil

When the initial sanctions on Russian oil were announced, the IEA forecast that a 3 million bpd of Russian oil would come off the market.

In April, the data showed a decline in Russian oil production as some production was shut in due to a lack of customers for Russian oil exports. However, this was quickly reversed as Russian oil found new buyers in China and India to replace the lost European customers.

It was only natural that prices would decline somewhat once the market realized that less Russian oil has come off the market than the IEA predicted.

Traders should be aware that some of the sanctions on Russian oil don’t come into effect until the end of the year, so it is possible that Russian oil exports will take another hit at the end of 2022, causing prices to rise. However, it is just as likely that by that point, Russian oil companies will have well-established relationships with their new customers, so the sanctions won’t hit significantly enough to impact the market at that point.

3. Discounts on sanctioned oil

Once Europe and the U.S. imposed sanctions on Russian oil, many refineries stopped buying oil from there, even though if the sanctions don’t take effect until the end of this year or later.

To attract new customers in other regions, Russian oil companies started offering hefty discounts on their oil. Iran and Venezuela also sell their oil at significant discounts because their oil is also under U.S. sanctions.

There is so much Russian oil available, that a price competition of sorts has emerged between Russia, Iran, and Venezuela and has pushed prices on the sanctioned oil market even lower. This can impact the global oil benchmarks as well, though we probably won’t see the full effect of this until Gulf oil producers start dropping their official selling prices to Asia. So far, this has not happened, but it could be in the cards, especially if a global recession causes demand in Europe and the U.S. to contract.

Many analysts believe that oil market fundamentals (supply and demand) indicate that the current price drops will not be sustained over the next several months and that we will see a return to triple digits.

A great deal hinges on whether the global economy enters a recession and the extent that demand declines as a result. Global oil supplies are unlikely to increase significantly enough to bring down prices at current demand levels, so traders should focus on whether demand will remain steady, grow or decline.