The oil market's real weakness is supply, not demand

Purveyors of conventional wisdom would have you believe that the 25% drop in oil prices since late last year was due to softening demand in slowing economies. They – and you – would be wrong. The real problem is too much supply.

Paradoxically, almost all the unanticipated production is coming from OPEC+ countries that are under Western sanctions: Russia, Iran and, to a lesser extent, Venezuela. Put simply, the black market for oil is booming. If one has the appetite – and the stomach – to buy crude from Moscow, Caracas or Tehran, the barrels are there. Better yet, they're available at a discount.

For instance, Iranian production hit a four-year high last month, up nearly 50% from mid-2020, just as Tehran accelerates its nuclear program and intensifies a crackdown on domestic opposition. Much of that oil is ending up in China under different guises, often rebranded as originating in Malaysia, traders tell me.

Supply up, prices down

Oil prices have fallen 25% since late 2022 as output from Russia, Venezuela and Iran – all under sanctions – has proved stronger than expected

Data from the Paris-based International Energy Agency, which publishes benchmark supply and demand balances monthly, provides the big picture. 

Compared to six months ago, the IEA has lifted its forecast for 2023 global oil demand by nearly 400,000 barrels a day, reaching a record annual daily average of 102 million barrels. Let that sink in: even as the Federal Reserve and the European Central Bank increased interest rates, and Wall Street predicted a recession, the outlook for oil demand has only strengthened.

Perhaps the IEA is overoptimistic and oil demand growth will slow. But its forecast already incorporates a pessimistic outlook for diesel, the fuel most exposed to the business cycle. The current IEA forecast for a 2.2 million-barrel-a-day increase in oil consumption this year comes despite its view that global diesel demand will contract.

Right now, the oil market is paying too much attention to the political and economic ups and downs in Washington. True, the US is still the world's largest oil consumer, swallowing two of every 10 barrels pumped worldwide. But America isn't the oil market. Its consumption lead has narrowed significantly in recent years, and in 2023 the combined consumption of China and India (21.4 million barrels a day) is expected to be larger than the US (20.3 million). 

The strength in the developing world matters. "We are seeing very strong demand, especially in Asia. Chinese recovery has been faster and stronger than expected," Toril Bosoni, the IEA's head of markets, told Bloomberg Television on Tuesday. "This is contrasting with the sort of economic gloom and the concerns we see for the global economy."

The real problem for the oil bulls – and countries like Saudi Arabia eager for higher prices – is supply and the need for cash in sanctioned producers. Over the last six months, the IEA has lifted its forecast for Russian, Iranian and Venezuelan output in 2023 by a combined 1.3 million barrels a day, reaching an annual average of 14.3 million barrels a day.

As with demand, there are risks to the supply outlook. Perhaps the agency is over-optimistic about Russia's ability to pump extra crude. But, if anything, the IEA has been too pessimistic about Moscow since it invaded Ukraine more than a year ago. A year ago, for example, the agency predicted that Russian output would plunge in 2023 to an annual average of 8.71 million barrels a day. In April, Russia produced about 10.93 million barrels a day. To reach an annual average of 10.73 million, as the IEA is now expecting, Russian production would need to decline. It may happen, as Moscow has promised to cut its production. But so far, it hasn't delivered on the cut, and I expect it would continue to pump at will, trying to make up via volume what it's losing due to lower prices.

Is the extra supply from Russia, Venezuela and Iran a sign that the Western sanctions aren't working? No. It's a sign the sanctions prioritise keeping the oil market well supplied, even if that means that Moscow, Tehran and Caracas can sell oil. Ignore Western politicians talking about using sanctions to cripple rogue petro-dictators; what they want is to cripple inflation. For now, the strategy has worked. It remains to be seen if it will survive the summer, when oil demand growth is likely to accelerate.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.