Are high oil prices sustainable?

Many commentators believe the solution to high oil prices is high oil prices. This paradoxical statement points to evidence that high oil prices stimulate production and depress demand, leading to a rebalancing in the market and a moderation of prices. Faced with an increase of over USD25 per barrel (pb) in the price of WTI oil between June and September it is natural to ask whether the automatic adjustment mechanism is still effective (see Chart 1). 

Chart 1. Oil and crack spread

Source: LSEG Data &Analytics and EFGAM calculations. Data as at 09 October 2023.

Furthermore, recent tragic events in Israel are seen by many as an additional factor that will keep prices high for a long time.

However, the factors that caused the price increase over the summer and the associated dynamics must be considered. The main cause of the increase in oil prices since June 2023 was production cuts totalling 1.3 million barrels per day (mbd) announced by Saudi Arabia and Russia - the de facto leaders of the OPEC+ cartel that controls half of global crude oil supply. Initially, the cuts were intended to apply only to the month of July, but they were extended twice for a month before the announcement in early September that the cuts would remain in place until at least the end of the year.

Estimates by the International Energy Agency (IEA) show the production cuts played a decisive role in creating an oil supply deficit in the second part of 2023 (See Chart 2). It should be noted, however, that the 2023H2 deficit follows several quarters of oversupply that resulted after the surge in oil prices when Russia invaded Ukraine in February 2022. IEA estimates indicate that if the production cuts end at the end of December, as currently planned, the market would once again find itself with large excess supply. But this also suggests further production cuts would be needed to extend the current supply deficit, a scenario that seems unlikely in light of the financial needs of Saudi Arabia and Russia.¹

Chart 2. Global oil market balance (mbd)

Source: International Energy Agency and EFGAM calculations. Data as at 09 October 2023.

Furthermore, the IEA has highlighted that rising prices and lower OPEC+ supplies have stimulated extraction in other countries, including the US. According to data from the US Energy Information Administration (EIA), US oil production increased by 0.6mbd between June and September, mitigating somewhat the tightening of the oil market.

Another interesting development is the collapse in refining margins, or crack spreads, that has been ongoing since the second half of August, after oil prices surpassed USD85 pb (see Chart 1). This reflects the difficulties refiners are having in passing on raw material price increases to final consumers. EIA data shows that US demand for petroleum products fell 12% between mid-August and late September while inventories of refined products, including gasoline and diesel, rose 5%. This evidence suggests that demand for crude oil from refiners will remain weak in the near term.

To re-establish attractive conditions for refiners, refining margins must rise. This may result from a combination of higher prices of refined products, which seems difficult starting from already high levels, and a decline in the price of crude oil, as has often happened in the past in similar conditions.

In conclusion, current high oil prices do not appear sustainable. Despite the production cuts implemented by Saudi Arabia and Russia and renewed tensions in the Middle East, the automatic mechanism for rebalancing oil supply and demand is already underway. In the absence of new supply shocks, oil prices are expected to moderate over the next few months.

¹ Saudi Arabia’s Vision 2023 plan to diversify the economy from oil is estimated to cost up to USD3 trillions, or 300% of current Saudi Arabia GDP. Russia is estimated to spend about 10% of its annual GDP on defence, primarily to fund the war in Ukraine. In both countries, the energy industry generates more than 40% of total fiscal revenues.