Banking Crisis Poses Threat to Oil Demand

The recent events in the banking sector have thrown oil into turmoil and whacked market bulls betting on higher prices. Speculators had built significant long positions expecting that Chinese demand would rebound aggressively while Russian supply would eventually taper. But so far, this has not materialized. Instead, several bank collapses have sent a shiver of panic throughout the global financial system, shifting the main oil demand drivers from geopolitics to credit conditions. Uncertainty about how central banks may avert a new financial crisis without undercutting efforts to bring down inflation has translated into higher, short-term volatility in credit markets and staved off appetite for risk assets like oil. Speculators have cut their bullish oil bets by almost half over the past two weeks, from 581,866 to 291,901 net long lots. The liquidation of Silicon Valley Bank (SVB) in the US and the forced merger of failing Credit Suisse with UBS by the Swiss authorities have raised again the specter of wider systemic default. While nobody is expecting a repeat of the 2008-09 financial crisis, which saw global oil demand drop by about 1 million barrels per day in each year, the potential for the banking crisis to spur a severe recession remains a concern. Other recessions, including 1990-91 and 2001 saw demand growth weaken but not contract. For now, Energy Intelligence is maintaining its forecast for global demand growth of 1.5 million b/d to 101 million b/d in 2023, which is less bullish than forecasts from the International Energy Agency and Opec.

Regionally, the US appears the most vulnerable because, unlike Switzerland, the banking crisis there remains unresolved. But Europe is at risk too. The combination of higher rates, tighter credit access and fickle business sentiment has degraded the economic outlook in both regions. In Europe, lending rates are likely to increase, potentially hampering investment in a region that is more reliant on banks than on bond or equity markets. In the US, credit constraints will increase the odds of a hard landing for the economy. Too much stress could push both regions into recession and force borrowers into default instead of boosting investment in new supply, refining capacity, or the energy transition.

Oil traders, which primarily get their credit lines from bigger banks with large reserves, are less impacted by the crisis. Instead, the onus is on household demand. Smaller banks may see their deposit base shrink. In the US, they account for a sizable 43% of all commercial bank lending. In Europe, they make up about 18% of total banking assets, but a sizable 45% of the euro area’s GDP. They are key to both the US and European economies, especially in terms of boosting household consumption, construction and oil uses related to these segments. The risk of a credit contraction may eventually drag these economies into recession. Credit is a key tenet of the economic recovery on which most oil demand scenarios are based. US Treasury Secretary Janet Yellen said last week that, following the SVB bank collapse, the government would not provide blanket deposit insurance, prompting concerns among depositors. Some may be less willing to leave their savings in small banks if they feel they are not well protected. In the week ended Mar. 15, $120 billion worth of deposits were withdrawn from small banks, while $67 billion were deposited at larger ones.

Central banks’ response has once again garnered attention. The recent banking failures show the tensions between price stability and financial stability in a higher interest rate environment, where it becomes harder to disentangle both. The US Federal Reserve is facing a difficult conundrum. If it continues to hike interest rates and shrink its balance sheet, global finance may face a stability issue and ultimately a recession. If it backs off too soon, its inflation targets may lose credibility, which could be even worse. The balance sheet of the Fed is the money market funding of capital market lending. When the Fed is doing some quantitative tapering by hiking rates and reducing its balance sheet, as it is now, it slows credit creation and drains the life from the economy. Meanwhile, the private banking sector must absorb more of the debt the Fed is offloading, which weighs on private banks’ balance sheets and solvability. As US Fed Chairman Jay Powell explained, tighter credit conditions and declining bank lending would have a similar impact as rate hikes. But if the Fed executes a policy pivot too early and starts cutting rates again, its intents will be seen as moot and fluctuating, and markets will no longer heed to its signals. Inflation expectations will become even more unanchored, and instead of subsiding, inflation will linger unpredictably.