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Omicron introduces downside risk to Oil

The energy markets are at an inflection point that is largely being governed by the current Omicron COVID-19 variant. If the new variant doesn’t cause massive disruptions to the economies most affected the demand destruction for oil will be less severe. However, if this spirals into are-run of 2020 the global economy will have a hard time coming back from the brink so soon after having to do so before.

Commodity Analysis – Oil

Brent crude oil futures prices fell by 11.6% on November 26, 2021, after the World Health Organization (WHO) classified the SARS-CoV-2 Omicron variant as a "Variant of Concern". As a result of the Omicron variant, the market expects oil consumption to fall in the short term. We are already seeing major economies bring in restrictions of movement from areas of high infection and the Omicron variant has reached 60 countries at the last time of checking.

Market analysts are predicting that Brent prices are expected to average USD 73/b in 2022 and USD 66/b in 2023, down from USD 79/b in 2021. The Brent crude oil spot price averaged $81 a barrel in November, a decrease of $3/b from October 2021, but a $38/b increase from November 2020. At that time the US dollar index was range-bound between the $93.40 and $94.50 levels. After the US dollar appreciated, Brent started to retreat from its highs. With regards to the markets last month, November was a significant month for many reasons and was also a period when traders were also absent from their desks due to respecting holidays.

On November 11th, 2021, after a small bounce from the lows in early November the Organization of the Petroleum Exporting Countries (OPEC+) lowered its 2021 forecast of global oil demand by 160,000 b/d due to weaker economic indicators in China and India but indicated the market would remain tight for the remainder of the year. China had reinstituted lockdown measures in some areas to contain growing COVID-19 cases, while cost-conscious Indian consumers eased back on oil use amid surging prices.

In the US, Thanksgiving was the day before November 26, which is when the front-month Brent futures contract expired. The announcement of important news concerning global petroleum markets at a time when market participants rebalance portfolios may have also contributed to crude oil price volatility on a low-volume holiday week. It was the perfect opportunity to move a market if you needed to but also the algorithms would have been triggered as the volatility and price action tripped stops.

Sometime in 2022, the completion of the tapering process by OPEC+ is expected to take the market from a situation of undersupply to one of oversupply, as represented by OECD inventories, which are expected to increase both relative to the five-year moving average and the pre-shale boom average. OECD commercial inventories will rise by 85 million barrels by 2022, according to the EIA. The release of strategic petroleum reserves (SPR) by some of the key consumer countries, including the US, adds further support to a scenario of an abundant supply of oil next year. Though the US SPR release is a very small dent in global daily consumption levels.

Currently, demand remains below pre-pandemic levels, but this gap is expected to narrow in 2022 with the end of winter and a likely resolution of tensions surrounding Nord Stream 2. The EIA is forecasting a dip in consumption between now and the first quarter of 2022 before consumption picks up into H2 2022.

As oil prices rose through H2 2020 into 2021 US production was shown to increase too. Rig counts are still steadily increasing but remain 30% lower than they were pre-pandemic. Shale producers are flexible and able to quickly activate new wells, so there is a lot of potential under the ground which could be brought to market quickly if prices remain attractive. The shale producers need higher prices to remain due to their higher CAPEX. The United States will account for the single biggest increase in output for a second month running, according to the International Energy Agency (EIA), as drilling picks up there.

If the OPEC+ group to which both Saudi Arabia and Russia belong, fully unwinds its production curbs, the two countries could also set records for annual production. Due to highly uncertain global demand, rising competition in the US, and the injection of strategic reserves into the market, OPEC+ has adopted a flexible approach to its tapering process.

They have also been forced to adjust as some countries were falling behind in their production due to disruptions. In January, OPEC+ currently plans to add 400,000 b/d to production, but it has the flexibility to change that at short notice if the global health situation deteriorates and impacts consumption. OPEC+ faces a challenging environment when it comes to tapering and with recent events escalating fast in the UK and Europe, they will have to make a last-minute decision based on the data they have and guess what the future may bring.

The latest US CPI reading came in at 6.8% over the last 12 months with energy up 33%. Prior to the CPI release, there was an effort by the Biden administration to make it clear that the high CPI reading didn't consider the latest drop in oil prices. President Biden has made it clear that he requires energy costs for the average American to reduce but he has also made it a policy to reduce support for carbon projects, most notably with the cancellation of the Keystone Pipeline. I am sure President Biden will find it hard to backtrack on the environmentally led policies, but his mid-term elections may be a harsh reflection should OPEC+ not increase global supply sufficiently.

From a technical point of view, the November 26th drop and proceeding decline to the $66/b level has now been retracted by 61.8% and the $75/b level is acting as solid resistance. For traders looking to join in with the diminishing demand and increasing supply narrative, taking a short speculative trade around these levels with risk mitigated above the $77 level or recent swing highs may be the most logical trade. The mainstream narrative around the Omicron variant is that it is a real concern and economic activity has been diminishing due to worries around the variant. In the UK the threat of not being fully vaccinated, boosted, etc. is translating into people canceling plans and returning to a work-from-home lifestyle. These actions in themselves cause the demand destruction but the knock-on effects are an economic decline which is proving to be hard to come back from. A drop from current levels to test the lows would have a decent risk-reward ratio.

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