Demand Shocks, Supply Shocks and Oil Prices: Implications for OPEC
Nowadays, oil market observers often start their analysis by pointing to two sets of factors pushing the oil price in opposite directions. On the one hand, supply outages from Iran and Venezuela and the rising geopolitical risks in the Middle East as US-Iran tensions escalate are keeping an upward pressure on the oil price. On the other hand, the US-China trade war and a general deterioration in global macroeconomic indicators are preventing prices from moving higher. In the background, the usual factors, such as whether OPEC will extend its cuts to the end of 2019, or even beyond, and the performance of US shale, will continue to shape market expectations and price outcomes.
While it is relatively easy to construct ‘bullish’ scenarios in which oil market balances remain constructive and OECD stocks fall in the second half of 2019 – with the impact (in barrel terms) of supply outages from Iran and Venezuela and potentially Libya more than offsetting the impact of lower oil demand growth due to a weaker global economy, this type of analysis is too simplistic given that the shocks that hit the oil market are not alike. There is plenty of evidence to suggest that the nature of the shock matters and that demand shocks and supply shocks do not have the same impact on oil prices, with demand shocks being more persistent and having a bigger impact on oil price movements. In a similar vein, not all supply shocks are alike and historically the impact of exogenous supply shocks due to geopolitical outages has been shown to be short-lived, while demand shocks in the face of capacity constraints can have a persistent impact. Thus, building a case for a sustained rise in oil prices based on geopolitical outages and the ‘war risk’ premium on their own is not realistic in the current context of weaker demand prospects and when key OPEC members are cutting output to levels below their agreed quotas. In contrast, any deterioration in global oil demand prospects remains the biggest drag on oil prices. In fact, one could argue that in so far as geopolitical tensions act as a dampener on global growth by undermining investors’ confidence and pushing oil prices higher, as demand for precautionary purposes rises and the ‘war risk’ premium becomes more important, the recent rise in geopolitical tensions are not necessarily supportive of oil prices in the medium term. In this presentation, we provide evidence on the importance of identifying the nature of shocks when analysing oil market dynamics and oil prices and what these shocks imply for OPEC’s next move.