What Is Causing Oil Prices to Fall?

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The oil market is in the midst of an extreme makeover. In three trading days, Brent fell to $70 per barrel from $82/bbl.

Typically, the oil price follows expectations of where demand and supply will meet in the months ahead. The arrival of the new Omicron variant of the Covid-19 virus can limit oil demand growth, and the coming release of crude oil from national strategic petroleum reserves (SPRs) will increase supply.

But both of those actions delay trends, not create new ones. The recent price swings seem to have taken their direction from the financial oil market, where risk capital is running for the exits. What’s explaining the change in sentiment?

Brent fell 15% in three days. Is that a surprise?

Yes, it was definitely a surprise. Before the fall, Brent had averaged over $80/bbl for more than eight weeks. Investment banks had been saying that they were expecting $100/bbl before seeing $70 again. And the Opec-plus coalition was thought to have put a solid floor under prices by keeping the crude market tight.

In addition, the natural gas supply shortage would create more demand for diesel and fuel oil to generate electricity. The trans-Atlantic skies are reopening, giving jet fuel demand a boost as well. Predictions were rife that a cold winter would be pushing this market further into a product deficit.

However, there were already some adjustments in thinking. Fuel-switching was coming in toward the lower end of expectations, and a new wave of Covid-19 infections in Europe was lowering growth forecasts for jet fuel demand, even before the new Omicron variant hit the headlines.

Both of those factors are not changing the dynamics of a tight winter. What they did foment, however, was a change of heart in risk capital, which had already been lowering bets on higher prices since Brent moved over $80/bbl in early October — despite some of them predicting further rallies. That selling became a waterfall once oil began sliding on Friday.

Friday's price collapse coincided with the Omicron variant becoming a public name. Is this drop linked to Covid-19 fears?

We don’t know much about Omicron yet, nor its potential impact on oil demand, but we can attempt to use the recent past as a guide.

What we saw with the Delta variant this summer was that it slowed down oil demand growth but it didn’t stop it, as product prices raced to seven-year highs.

But the arrival of Omicron and its uncertain impact seemed a good moment for market players to take profits — or minimize losses. It seems fair to say now that Omicron itself will not likely have a dramatic impact on oil demand, but its arrival was a key catalyst for the price collapse.

That the big fall happened during the Thanksgiving holiday in the US is also key. Much of the trading was left to computers. Once prices started falling, machines sold what they were told to, technical chart trading kicked in, the options market started selling futures contracts and margin calls forced even more sales. Portfolios needed to rebalance.

The price collapsed in a cascade of intertwined financial positions. It has happened many times before and is always dramatic.

What about other factors, like the US' SPR release and big drops in equity markets?

From a fundamental perspective, the release of oil from the SPR is a symbolic act. Yes, it adds to supply, perhaps some 60 million bbl, but that is well flagged and not terribly significant in the grand scheme. If these releases would impact oil balances in any way, Opec-plus could easily counter.

The recent rise in US oil output has had far more of an impact. US crude production is currently roughly 340,000 b/d higher than what was expected in the fourth quarter, and liquids are 60,000 b/d higher. That is real oil, adding 37 million bbl in the fourth quarter alone, and is expected to continue into the new year.

The market was already facing an oil surplus in the first five months of 2022. Energy Intelligence estimates see put that surplus at about 1.6 million b/d during that period, which includes softer pandemic demand and rising US oil output.

If anything, some players are waking up to the fact that there will be a surplus — and they might have just closed their books for the year. The Dow Jones Industrial Average is down 4% since the days preceding the Thanksgiving holiday — while not a massive drop, it is a sign that growing uncertainty is forcing some capital to close their positions, which is what also happened in oil.

So how much of the price fall is due to a change in market psychology, and how much is due to fundamentals?

Sentiment is crucial. For now, oil fundamentals haven’t changed much from what was known before the Friday fall. The price of oil is trying to put a value on events that have not happened yet. Omicron is one addition. The talks on the Iranian nuclear deal have also started. But few traders expect that to result in a lot of new oil any time soon.

Not much else is different. Uncertainty always leads to a market reaction, and rapidly flowing risk capital exacerbates the swings. One could argue that even before the recent collapse, speculators had already artificially inflated the oil price since they all sit in the front-month contract, where most of the liquidity is.

On Friday, and again on Tuesday, the tail was wagging the dog. It was 90% sentiment and 10% fundamentals.

Are oil prices expected to bounce back, or will volatility and weakness persist?

That is asking: what is a fair price for oil? Until a few days ago, the market said $80 was fair — now $70 is fair.

If anything, this would be a moment for Opec-plus to consider its options. Producers would rather see $80/bbl oil, or even higher, and they will try get it back there.

They might get help from the products markets, which remain tight. Refiners are late on ramping up runs. The world running short on diesel would push Brent back to $80/bbl in no time.

We have said this would be a wild winter before surpluses usher in a calmer spring. The oil price is already bouncing around, and winter is only beginning. The extreme volatility of recent days is not sustainable, but price swings remain a hallmark of the season.

Oil Futures and Derivatives, Oil Prices, Oil Demand, Oil Products, Crude Oil, Oil Forecasts, Supply & Demand , Opec-Plus Supply
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