Oil prices have fallen. So why do imbalances between supply and demand persist?

Andrii Yalanskyi

Oil prices have retreated from recent highs as demand concerns and growing recession fears take center stage in global markets. Greg Bonnell talks to Daniel Ghali, Senior Commodity Strategist at TD Securities, about why crude prices don’t reflect current prices supply and demand challenges.


Greg Bonnell [00:00:03] All of these recession fears triggered a major outflow from commodity funds, sending crude tumbling from recent highs. But our next guest says that the price action does not reflect the true dynamics of supply and demand in the sector. Joining us is Daniel Ghali, Senior Commodity Strategist at TD Securities. Daniel, welcome to the show. Great topic. Let’s cut to the chase because people are trying to figure this out. What does a possible recession mean for crude and what is really happening in the markets? What’s really going on?

Daniel Ghali [00:00:29] Yeah, absolutely. And listen, thank you for inviting me. I think over the last week what we’ve seen are the largest commodity outflows since 2014. That statement itself is actually very important because what it says is is that the pace of commodity fund outflows over the past week was actually faster than seen during the COVID 19 panic. What is driving this? Well, recession fears have certainly been front and center for most fund managers, and I think that’s mainly why we’ve seen this. What he’s hiding, however, is that behind the scenes physical markets have actually tightened and they’ve sent a strong signal that brent, for example, in physical markets is actually scarcer today. today than it was a week ago. It’s really a dichotomy between what the futures markets are signaling and what the physical markets are signaling. From a fundamentalist point of view, really, nothing has changed. We see severe constraints on oil production over the next year or so in the United States after all the shale slabs print silver. And that certainly means that the incentive to reinvest this financial windfall into operations is at its highest level in more than a decade. However, we see that expectations for capital spending are rising only modestly. And in fact, when you take inflation into account, they’ve only increased to such an extent that you’d expect the rate of output growth to remain stable or at levels similar to today’s. today. Well, where else in the world can we get more oil? Let’s talk about OPEC. OPEC has been undersupplying on a sustained basis over the past year. It’s the result of a decade of underinvestment or underinvestment in energy infrastructure coming back today. We know that several OPEC countries have operational constraints, but geopolitics has also been a major impediment to increasing oil production. Not just with regard to Russia, which we’ll talk about in a moment, but several nations, including Iran, which of course the world is looking to the Iran nuclear deal as a potential avenue to increase oil production. . But other countries, like Libya, have struggled in the midst of a political crisis, and that has limited the amount of oil we can get out there.

Greg Bonnell [00:02:49] It’s interesting, isn’t it? Because people, I guess, in traditional times or even during the pandemic would say, look, if we were to actually get into a situation where demand exceeds supply, then we watched OPEC meetings and we say, oh, they’ We’re going to ramp up production, so it’ll be fine. But there have been many question marks as to their actual abilities. If we need much more to meet the demand, if we even meet that demand.

Daniel Ghali [00:03:10] Yeah, absolutely. I mean, at the rate of production today, we’re really operating at the lowest spare capacity levels we’ve seen in a very long time. This means that any oil shock will be very difficult to absorb. So even if you’re looking at a recession next year to slow the rate of oil demand growth and therefore to balance the markets in that way, well, historically there’s really only been four periods over which oil demand growth was negative year-on-year. This is the OPEC embargo in the early 1970s, the Iranian revolution, and also in the 1970s, the global financial crisis and COVID 19. Apart from these extraordinary cases, every other recession has not happened. reflected only in a slowdown in demand growth. But yet, what this means, and this is a critical caveat, I would say, is that we are going to further erode what little is left of the world’s spare capacity. And the big picture here is that means supply risk is going to remain in oil markets for the next year.

Greg Bonnell [00:04:17] Given that, why don’t we see the investment in future production? Are these just timelines that companies don’t want to commit to if they think we’re heading to a future where we’re not so carbon dependent and they say wait a minute these are big investments. We just don’t want to make them?

Daniel Ghali [00:04:33] I don’t think that’s the case. I think, you know, ESG has been a major driver of lower capital spending in the shale play, but also overseas and globally. What we have seen is that sectors that are more carbon intensive tend to be associated with lower reinvestment ratios. And so what that tells us is really the ESG theme that drives the higher cost of capital to reinvest in your operations when you’re in a capital or carbon intensive industry and also say that right now we are in a period of time where the supply chain in the energy sector also limits the ability of companies to increase their production. In the United States, of course, these are private companies and they therefore have a clear incentive to increase the growth of their production. But we think manpower is scarce, equipment is scarce, and historically you’ve been able to cannibalize some spare parts from past operations. But today that has been done and supply chain disruptions are also hampering their ability to scale up production.

Greg Bonnell [00:05:40] Sounds like maybe we’re leading into a discussion on the refining part of the energy space, doesn’t it. It’s one thing to say production, get the rough, find the rough, get it out of the ground. But the refining ability requires humans. You need the infrastructure. Do we follow that front either, I mean, new refineries, you know, those are very expensive proposals?

Daniel Ghali [00:05:58] Correct, absolutely not. And that’s one area where the long-term destruction of demand that people expect to have for oil limits the amount of money that goes into the refining sector.

Greg Bonnell [00:06:08] What does this mean for the price of oil in the future? I mean obviously we’ve had a pretty wild ride so far this year. And then as it trickles down to the average person, even beyond, like, you know, our scope as investors, we feel it when we’re filling up cars, when we pay our energy bills. Where do you think we are going in all of this?

Daniel Ghali [00:06:22] Well, I think the point here is that supply risk is going to continue to stay priced into crude oil prices. And so, while you usually expect a recession, crude oil prices tend to drop 50 or even 75%, this time around it’s not going to be anywhere near. And so we’re going to see oil prices stay high for the foreseeable future.

Greg Bonnell [00:06:40] You talked up front about the disconnect that we’re seeing between the futures market in terms of, you know, maybe telling us about the demand for crude going forward and the actual physical market. Will there ever be a situation where we can somehow bridge that disconnect between what the future tells us and what the physical market is? Still a bit of friction there.

Daniel Ghali [00:06:58] No, absolutely. I think that kind of disconnection doesn’t happen for a very long time. And so we expect the futures market to revalue in line with what the physical markets are saying. The reason futures markets are disconnected is because of the extremely large outflows we’ve seen in commodity funds. And so if you know them, they contain a basket of basic products. And as the fund managers who hold these funds worry about a recession, they withdraw their capital. This results in a blind sale of all products. And that’s why there may have been a pricing error here.

Greg Bonnell [00:07:33] It is extremely difficult to link the markets. You say you saw these huge cash outflows. Are there any signs that you are looking for stable stabilization there? Kind of. I think we’re all looking for some kind of guidance, whether it’s commodity markets, equity markets, some sense of, things have calmed down, are they going to stay calm or are we still in a difficult ride?

Daniel Ghali [00:07:53] I think we are still in a tough race here. I mean, the thing is, the reserve capacity is extremely low and that means any shock will be very hard to absorb. But we are also in a period where the probability of a shock is extremely high. We know that high energy prices, a high US dollar and a rising Fed tend to be associated with turmoil in the emerging markets world. And so emerging market producing nations could start to face some turmoil next year that could inhibit their ability to produce oil, and that’s a potential source of supply shock on the horizon.

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