I’m Skeptical of the Higher Oil-Price Meme

The prevailing opinion among analysts is that a tighter market in the third quarter of 2024 will push oil prices higher as demand exceeds supply. I’m skeptical of those bullish predictions because we’ve seen this movie before, and it ended badly.

The U.S. Energy Information Administration (EIA) forecasts Brent crude prices to average around $89 per barrel for the remainder of 2024. Standard Chartered predicts that Brent prices could exceed $90 per barrel and dismisses recent price decreases as “idiosyncratic.” Similarly, ING expects Brent to average $88 in the third quarter.

These views have become memes—slogans that reduce complex situations to their simplest form, imitations of reality.

“Memes translate complex ideas into simple, emotionally evocative messages that construct the narratives that frame events and tell us who are the heroes and villains.”

Psychology Today

There are, however, a few outliers to the current oil-price meme. Citigroup projects a Brent average price of $82 for the third quarter but anticipates a decline to $74 per barrel in the fourth quarter, and a drop to an average price of $65 in the first quarter of 2025. Fitch Ratings expects an $80 average Brent price for 2024, and forecasts that prices will average only $70 per barrel in 2025.

The “China Rebound Meme” and “Deficit Meme” dominated analyst expectations in late 2022 & most of 2023 but geopolitical events had at least as much effect on oil prices (Figure 1). So far, the 2024 Deficit Meme has disappointed expectations.

The China Rebound narrative emerged in late 2022, as China lifted its COVID-19 lockdowns, prompting analysts to forecast a surge in demand that would drive oil prices much higher. Later, the Deficit Meme took hold, fueled by projections of a significant global oil supply-demand shortfall following increased OPEC+ production cuts in May 2023.

Regardless of causes, oil supply deficits in 2023 and 2024 were relatively minor compared with those in 2022 (Figure 2). The much-anticipated China Rebound and Deficit Memes amounted to much ado about very little, as the expected surges in demand and significant supply shortfalls failed to materialize as dramatically as predicted.

How did analysts miss the mark so significantly?

First, the match between the oil supply-demand balance and prices is abysmal (Figure 3), with a correlation coefficient r² of just 0.11. Additionally, OPEC’s forecasts have become increasingly overstated, as the organization aims to bolster its leadership’s policies. OPEC hasn’t adjusted its past over-estimates to better align with reality, resulting in a significant loss of credibility.

Supply and demand are, at best, rough approximations. It’s impossible to accurately compile and integrate the production, consumption, and export data from every country into a single cohesive model. The necessary data is simply unavailable. Moreover, supply and demand are transactional measures that don’t include the critical factor of storage, which significantly affects the mechanics of oil price formation.

The supply-demand balance method assumes that the normal state of markets is equilibrium, with occasional excursions into disequilibrium. Comparative inventory (C.I.) provides a more accurate framework by recognizing that oil markets operate as a disequilibrium systems. The resulting correlation to oil price is about seven times better than the traditional supply-demand balance approach.

The most reliable inventory data outside of the United States comes from the OECD (Organization for Economic Cooperation and Development). Its 38 member countries account for half of the world’s energy consumption, three-fifths of world GDP, and three-quarters of world trade.

OECD total liquids comparative inventory (C.I.) has shown a 78% correlation with Brent spot oil prices over the last decade. Figure 4 illustrates that the OECD liquids supply deficit for the first half of 2024 was only 30% of the levels seen in the first half of 2022. Not surprisingly, the average Brent price in 2024 was about one-third lower than during the same period in 2022.

That doesn’t mean Brent prices won’t rise later this year, but historical data suggests a significant increase is less likely. This view indicates that a price rally driven by geopolitical factors is more probable than one based solely on inventory or supply-demand fundamentals. Historical trends show that geopolitical events often trigger more substantial price movements than the gradual shifts in supply and demand.

Figure 5 presents the same comparative inventory and price data as a cross-plot, using quarterly values from the last three years. The red trend line, or yield curve, shows the correlation between C.I. and Brent price. The July data point plots on this yield curve, indicating that $87 per barrel is the marginal spot price for a comparative inventory value of 139 million barrels below the five-year average. This further suggests that the current Brent futures price of $82 is about $5 less than the marginal value.

When analysts project higher future prices, it implies a greater comparative inventory deficit. For Brent to reach $100 per barrel, C.I. would need to drop by around one hundred million barrels. While this is possible—as seen in 2021—such changes don’t happen by magic overnight.

The biggest events affecting oil prices this century have been the 2008 Financial Crisis, the Covid Pandemic and the Ukraine War. Secular inventory changes are driven typically by geopolitical and other first-order disruptions, rather than by fundamental market factors—markets are generally adept at navigating through those using price as a lever.

Reasonable explanations of current data often morph into memes when analysts become too attached to their models and interpretations. Instead of integrating anomalies into their frameworks, they explain them away. That’s when analysts get things wrong.

Then, when an unexpected event occurs, analysts claim that no one could have seen it coming.

We’ve endured nearly two years of failed oil-price narratives—the China Rebound Meme and the Deficit Meme. Now there’s a new meme in town that looks a lot like the last two. My bet is that it’s on its way to failure.

The underlying, longer-term trend for oil markets is increasing supply scarcity. That’s where the fundamentals come into play. This backdrop gives deficit narratives a head start, making them appear right for potentially the wrong reasons.

Geopolitics and major systemic failures are the more important part of the story that fundamentals begin. A relatively tight market only needs a small nudge from a war, financial crisis, or pandemic to escalate into a full-blown price shock.

The daily oil news drones on about the Chinese economy, tight physical markets, rate cuts, and peaking demand. While those are all valid, they are just memes. The smart money is following other, more interesting and more relevant trends.