Bearish Pressure On Oil Prices Remains Elusive

378913 01: Pennzenergy Company Oil Exploration Drilling Rig In The Gulf Of Mexico During Sunset. (Photo By Getty Images)

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These are confusing times for the oil market, with forecasts continually calling for a growing surplus, yet prices remain strong with some analysts suggesting a new spike is possible. OPEC+ has been criticized for unwinding the voluntary cutbacks more quickly than initially proposed, while fears of demand weakness due to uncertainty about U.S. tariffs suggests they might be overly optimistic about the market balance.

In my opinion, one of the best observations explaining market behavior came from John Maynard Keynes, who was an active trader and at one point had massive losses in his portfolio. He opined that economics don’t explain market behavior so much as traders’ perception of the market economics. That still holds true today, and in no place more so than oil trading.

‘Crisis fatigue’ is a known phenomenon where traders, facing lengthy geopolitical threats, ultimately grow weary and begin to discount the potential for, or impact of, supply side disruptions. Israel’s war in Gaza is one example, as violence involving that country and its various neighbors initially raised fears that the violence will spread to oil producing regions. Eventually, the perceived probability of a disruption receded and the security premium with it.

The equivalent now appears to be ‘recession fatigue.’ Fears of economic dislocation have put downward pressure on the price of oil since Trump’s inaugural, with government layoffs suggesting rising unemployment, deportations of workers raising fears of inflation especially for groceries, and tariffs appearing likely to boost inflation and depress spending. Yet unemployment remains low, inflation has only marginally risen, and the economy was strong in the second quarter.

But I recently came across a quote from M.I.T.’s Rudiger Dornbusch (in Ken Rogoff’s Our Dollar, Your Problem), who observed, “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they would.” In other words, just because it hasn’t happened, doesn’t mean it’s not going to. The impact of tariffs is hard to estimate because, first, they have changed repeatedly, including pauses of announced levels, and second, consumer spending might not reflect longer term activity but instead people and businesses front-loading their purchases to beat the tariff implementation.

The impact of government layoffs and worker deportations are also hard to estimate, but to date, the anecdotal reports appear to be much worse than the government data. Partly this is because some government layoffs have been paused by the courts, but also, the multiplier effect of the layoffs will take time to accumulate as unemployed workers cut back spending, weakening the local economies. The recent decline in the number of hours worked might be a foretelling of later weakness, but to date, employment levels are not seriously affected.

Interestingly, the data on oil demand are mixed: gasoline demand to date is down 0.6% compared to last year, suggesting consumer confidence is poor and people are not taking long driving vacations. On the other hand, distillate demand is 3.7% above last year’s, and distillate primarily reflects business activity, such as shipping goods. Possibly, demand surged with orders from consumers trying to beat the tariff imposition, but the evidence is too muddied to provide anything close to a definitive answer. Jet fuel, interestingly, shows continued growth, up 5.4% over last year, which contradicts the impression that consumers are less confident and not spending on long-distant vacations. Typically, jet fuel is the first to be affected by a slowing economy as businesses rein in travel spending.

On the supply side, many have been flummoxed by the failure of OPEC+’s production increases to dampen price expectations. Since March, when they decided on April production quotas, OPEC+ has repeatedly called for a rapid unwinding of the voluntary quota reductions of 2.2 mb/d. After each announcement, prices dipped but only briefly before recovering, partly in recognition of the fact that the expected surplus has not materialized as of yet.

This reflects the fact that the headline increase in OPEC+ quotas is well above the actual, since many members are already at full production. The voluntary cutbacks of 2.2 mb/d will, in theory, be gone as of August, but the increase in the first three months of the unwinding, expected to be 1.23 mb/d, was only 0.81 mb/d, according to IEA estimates. Supply in July and August is also likely to be less than the quota increase, as only Iraq, the Saudis and Emiratis have much spare capacity: the IEA estimates that they have 3.8 out of the 4.4 mb/d total spare capacity in OPEC+. In theory, Iraq and the Emiratis will not increase further, as they are supposed to be compensating for earlier over-production, but to date their compliance with quotas as been deficient.

The inventory picture vaguely supports the mixed indicators, with inventories growing some but less than expected. The IEA estimates that global oil inventories built over 1 mb/d in the first quarter, when they typically decline, and should have increased another 1.6 mb/d in the second quarter. Data and transportation lags mean that the build would not necessarily have shown up as of yet; OECD inventories grew by only 38 million barrels from end-December 2024 to end of May. Assuming the growth in global inventories is twice the OECD levels, that still means that less than half the expected inventory increase has shown up.

The broader dataset of what the IEA defines as observed stocks are thought to have grown by 1.74 mb/d in the second quarter, which is more in line with their projected market balance. However, the second quarter typically sees inventory builds as refineries undergo seasonal maintenance. Furthermore, a significant fraction of the stock build was in China and U.S. natural gas liquids, whose exports have been disrupted by the trade conflict with China.

So, the increase in OPEC+ quotas looks more prescient than misguided, reflecting actual inventory and price levels, as opposed to the IEA forecast of future stock builds. Weaker shale production in the U.S. could support this outlook, as could stronger sanctions on Iran and Russia. However, those sanctioned countries have a record of maintaining sales over the longer run, and shale producers have had a habit of outperforming expectations.

I would argue that neither the bear price case nor the bull price case is certain at this point. If supply holds up better than expectations, and inflation picks up in the U.S. as many, but not all, economists predict, oil demand and the market will definitely weaken and the possibility of an oil price spike will recede. Whether the price collapses will depend more on Saudi reaction to overproduction by Iraq, Kazakhstan and the U.A.E. If inventories do not grow much this summer, the Saudis will probably be in a conciliatory mood, but if the IEA project proves close to the mark, new reductions in the quotas can be expected. In that case, the Saudis would bring greater pressure to be on their recalcitrant partners.

Should economic growth in China and the U.S. prove robust, and sanctions reduce supply on the market, the bullish price case will prevail. Shale oil production is almost certain to underperform, given moderate prices at present and rising costs of equipment, especially due to steel tariffs. But quite possibly, any strength in oil prices will encourage the Saudis to push for higher quotas in an effort to cash in, rather than refuse to increase output in solidarity with Russia.

Ultimately, both bulls and bears have support for their expectations, but unless U.S. tariffs remain at modest levels and inflation isn’t ignited, oil demand growth is more likely to be anemic and only better sanction enforcement will support current price levels.