Oil Bulls Take Cues From Spiking Gas

The natural gas crisis in Europe and Asia is supporting the notion that there is no downside to oil prices. Global benchmark Brent and US marker West Texas Intermediate have breached $80 per barrel and look set to move higher on the back of fuel switching from gas to oil in power generation and industrial use. This would further tighten diesel and fuel oil supplies, and perhaps even crude. It is unclear how much oil is needed from fuel switching, but the low end of forecasts sees 300,000 barrels per day more demand in case of a regular winter, while the high end sees 750,000 b/d in a colder-than-normal winter. Many gas-fired power plants can run liquids, and with gas prices at the oil equivalent of $165/bbl or more in Europe and Asia the economics are clear. Substitution is also likely in countries that burn coal as dual fuel boilers are more often coal/oil than gas/oil. Oil demand for power and industry would likely come from heavy coal burning countries like China, India, Bangladesh, Pakistan and Indonesia. China’s call on the industry to buy energy “at any cost” to prevent outages has further stoked oil bulls.

On the face of it, the oil market should only get a marginal boost from the gas shortage. After all, Opec-plus has 6 million b/d of immediately available spare capacity; OECD nations hold 1.8 billion bbl in strategic petroleum reserves (SPR); and global refiners have lots of spare capacity and are keen to hike runs since margins are positive. But oil bulls argue these volumes will either fail to materialize or arrive too late. Instead, they see fuel switching further draining low inventories. The marginal barrel of demand sets the price, and for bulls $80 is not the end, only the beginning of a push higher. What good is spare capacity if Opec-plus is not willing to bring it to market, one broker notes. And if there is no supply disruption, just a tight market, others argue it could be hard to justify SPR releases. After Washington stepped back from Energy Secretary Jennifer Granholm's recent remarks that a SPR sale was under consideration, oil shot back up. Producers are increasing exports to Asian refiners, but Opec-plus leader Saudi Arabia barely sees additional appetite for its crude, one insider says. Even if refiners buy extra spot oil, November and December loading crude arrives at least a month later in Asia, replenishing product tanks in January and February — when a cold spell could have already drawn inventories. And if gas prices continue rising in the coming months, sentiment in oil markets could trace it, the bulls reckon.

Refined products are all trading in backwardation. The premium for prompt cargoes signals an undersupplied market where the balance of demand is met by taking fuel out of storage. The world still has leftover surplus products from the sudden demand collapse during the pandemic — but they are getting thinner. Refiners in all regions are now running at a profit after Europe and Asia joined the US in recent weeks. Demand for diesel and kerosene is seasonally higher in winter, and a cold one will increase fuel consumption. Additional fuel switching can create product price shocks — and a demand reaction. It’s anybody’s guess how long the gas crisis could last, but already low gas storage levels in Asia, Russia and Europe point to a potentially extended period of hand-to-mouth gas supply and price volatility.

The danger is that higher prices trigger demand destruction and cap economic growth. Inflationary forces are mounting around the world, while forecasts for economic growth are being revised lower. So far, this is not deterring oil bulls, however. Diesel and gasoline prices in California, on the US West Coast, are already over $4 per gallon, typically a red line after which consumers start limiting demand. High fuel prices are also pushing up costs for deliveries of all goods, with a risk of stoking inflation. Rationing of electricity to households and businesses is already happening in Asia, delaying the economic recovery from the Covid-19 pandemic.