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Even with the price of oil up more than 50% year to date, there appears to be little impact on demand. Greg Bonnell speaks with Hussein Allidina, Head of Commodities at TD Asset Management, about the potential impact of the summer driving season on prices.
Transcript
Greg Bonnell: We know that the high price of oil has been a major driver of inflation. Of course, we’ve seen some choppy trading and some weakness, particularly today. Got some lockdowns in China, some growth concerns out there. Our feature guest says demand, though, is already outstripping supply, not even as that summer driving season just yet. For more, we’re joined by Hussein Allidina, Head of Commodities at TD Asset Management.
Great to see you, Hussein. Let’s start here. A lot of pundits are saying you don’t wrestle inflation down until you can see a break in energy prices. The trade can be choppy from day to day. What are the actual mechanics of the market? Can people expect any relief?
Hussein Allidina: Sure. Greg, thanks for having me. I think that if we look at the oil balance in particular and where we’ve come from, sort of the lows of the crisis in 2020, inventories have been drawing pretty consistently over the course of the last 16 months and for the better part of this year inventories have also drawn, notwithstanding the fact that the US government has been releasing inventories from their reserves. When I look at the balance today and I look where we’re headed over the course of the summer, as you mentioned, typically your gasoline demand does increase seasonally and globally demand increases seasonally, somewhere between two and 4 million barrels a day from May to the end of the summer. If I look at the supply side again, I’m already in deficit as evidenced by drawing inventories, the supply side is not going to increase by the same magnitude. Maybe we get a million barrels a day of growth. So I’ve got a deficit today, a deficit that grows over the course of the summer. And my starting point for inventories is tight, and I think we get even tighter over the course of the summer. Your question about relief. I think that you need to see a material contraction in demand, a material contraction in growth before I’m able to get my demand line below my supply line. And that’s the only point where I get relief. I don’t see that happening in the near term.
Greg Bonnell: Relief then sounds like it only comes in the scenario that none of us want to see either, in which fears dominate the market, a recession.
Hussein Allidina: That’s right. And if we look at oil demand historically, there’s only a couple of episodes in the last 20, 30 years where aggregate oil demand has actually contracted. Around the pandemic when the world stopped, we had oil demand go negative. During the financial crisis 2008, we had oil demand go negative. Between 1990 and 2022, we’ve had periods of weak growth but still positive demand growth for oil. And I think this underscores the importance of oil as it relates to the global economy. If you want the economy to grow, you need to use oil. So the Fed posturing to reduce growth. If we want to actually see oil demand growth reduce meaningfully, we need to see a meaningful contraction in GDP. And notwithstanding the fact that the World Bank, the IMF, have been reducing their GDP forecast, they’re still numbers that point to positive oil demand growth, which means still tighter balances.
Greg Bonnell: There might be a school of thought out there that says, okay, if we see an increase of demand, a sustained demand, then you simply just wait for the next OPEC+ meeting and watch them increase the amount of barrels they want to pump on a daily basis. There are skeptics out there as well to that line of thinking. Walk me through that.
Hussein Allidina: So let me, let me just back up before we talk about OPEC and just talk about the global supply landscape for oil and for other commodities. We have to remember that we’ve come through a period, Greg, of probably 10 to 12 years into 2022 of weak commodity prices. That bear market in commodities following the peak around the financial crisis discouraged any investment OPEC, non-OPEC, in oil production. So we’re coming out of a ten-year period of under-investment, tight supply. We can see the projects that are expected in oil, in copper, and aluminum that are expected to come online at least over the course of the next three, five, seven years. Because these projects have long lead times, there’s a dearth of supply coming online. So am I going to get relief from non-OPEC? Very unlikely. There’s not a ton of incremental production growth expected and even in OPEC. And to your point, there is a lot of discussion, debate around the amount of spare capacity. We can stay away from that discussion for a second and just look at what the producers have been doing relative to their quotas. On average, OPEC has been producing under what they’re allowed or prescribed to produce. So that should talk a little bit to the amount of spare capacity that’s there. Most estimates that I’ve seen point to spare capacity maybe of two, two and a half million barrels a day from these levels. We’ve never produced at those levels. There’s a lot of skepticism around how sustainable that is, even if we are able to produce at those levels, the oil market, Greg, is 100 million barrels a day. We’re talking about spare capacity of maybe 1 to 2 and a half million barrels a day. It’s not a margin of safety that leaves me comfortable for sure.
Greg Bonnell: Another argument out there who’s saying that we wouldn’t be in this situation with energy prices and oil prices if it hadn’t been for the Russia-Ukraine conflict. Is that too simplistic a take on the market?
Hussein Allidina: So Russia is obviously a very large producer of oil and natural gas, particularly to Europe and to parts of Asia. I think the importance when we look at the numbers though is that the actual disruption in Russian volumes has been relatively muted. I think those volumes will decrease as the year progresses. A lot of the larger commodity trade houses have said, look, we have existing contracts with Russia that we’re going to honor through year end. We’re not going to do anything incremental. So I think that you will see Russian volumes fall even further. The actual drop in Russian volumes to date has been relatively muted. Russia not sending as many cargoes to Europe. Ultimately, those cargoes are making their way to China. India takes a lot longer, takes 30 days to get from Europe to China, versus three days to get from Russia, pardon me, to Europe. So there is a bit of supply that’s been impacted because of that. But we haven’t seen I think the magnitude of declines that are likely as time progresses and this conflict continues.
Greg Bonnell: Given the market structure you’ve been talking about, Hussein, what can we expect out of a price for a barrel of West Texas Intermediate? This is choppily trading along so many asset classes. A choppy day today. Going forward, though, what’s a range? A reasonable range?
Hussein Allidina: It’s really hard. So I think when I look at the summer and that landscape where demand is increasing and supply is not increasing as much and given how tight inventories are, I think that there is a real risk that prices could see new nominal highs this summer. The prior highs that we saw was 147 and change. I think we can go through that. Ultimately, though, the concern is, with the Fed tightening, with 24 of 36 central banks having tightened or posturing towards tightening, growth is going to come under pressure. How much that growth sort of declines or comes under pressure will ultimately dictate how sustainable the oil prices are. But if I had to sort of lay out sort of the next three, four months, I think we’re higher. And then I think as we get into the winter, you could see some relief, but not $70, $60 relief unless you expect growth to move into material recession, material contraction. And I don’t think that’s the base case right now.
Greg Bonnell: But that sounds like the biggest risk right now, even though you’ve laid out a base case about how the mechanics of the market work and where we are with supply and demand. Recession ultimately wouldn’t be great for a number of assets, including crude.
Hussein Allidina: In 2007, 2008, the fundamental balance was tight, not as tight as it is today, but it was tight. What took the oil price materially lower, from triple digits to the 50-60 range was a material contraction in GDP. If we see a material contraction in GDP, oil will trade down to $60, $70 a barrel. As demand weakens or if demand falls, in March 2020, when demand stopped, those supply constraints disappeared. The supply constraint only exists if you have demand. My base case is that demand right now is firm. And even with the weaker GDP that’s expected, I’m not expecting demand to fall meaningfully enough to address that supply constraint.
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