Oil risks remain on the upside

Oil prices have moved their attention away from the threat to supply caused by Russia’s war in Ukraine to considerable downside demand risks in China as the country grapples with comparatively serious Covid-19 outbreaks. China’s government appears committed to its zero-Covid strategy which involves highly restrictive lockdowns and mass testing but that come with the knock-on effect of severely curtailing mobility. That being said, at the same time the war in Ukraine has shown no sign of easing and supply risks still remain acute.

China’s Covid-19 response is markedly at odds with global peer economies. Measures to control the spread of Covid-19 have never eased substantially in China and have become more restrictive in recent weeks according to a government response stringency index published by Our World in Data. Unlike other major economies, China’s mobility activity has never come close to converging on pre-pandemic levels. In the US total road passenger traffic is now just 5% below 2019 levels while in China the latest national estimates are for traffic volumes more than 70% below that of 2019. Oil demand growth was already set to slow from the recovery bump recorded in 2021 but the risk from China again imposing wide and long-lasting lockdowns appears high.

China's mobility still well below pre-pandemic levels

Source: Bloomberg, Emirates NBD Research

The risk of a considerable slowdown in China’s economy is helping to alleviate the apparent tightness in oil balances. Russia’s invasion of Ukraine has prompted a flurry of direct sanctions on Russian exports and firms have continued to ‘self-sanction’ and avoid taking delivery of Russian crude or products. Oil prices have tumbled from a peak of USD 139/b in the Brent market in early March to around UDS 104/b at present while time spreads have collapsed: front month spreads in the Brent market have fallen from as high as USD 5.88/b at the start of March to just USD 0.20/b at present.

Brent time spreads crumble: 1-2 month spread

Source: Bloomberg, Emirates NBD Research

Push and pull

China’s heightened Covid-19 restrictions are a slow but negative force acting on oil prices and have opened up downside risks. However, the pathway is known considering the global economy has endured widespread restrictions during Q2 2020 and the demand response to restrictions being eased in other markets has been considerably positive.

Meanwhile the ongoing war in Ukraine and the risk that the EU imposes direct sanctions on imports of Russian crude oil and products are a substantial, and likely to be rapid, upside risk for oil. Diplomatic pressure is growing on the EU to firm up its stance on Russian energy imports, from both internal and external sources, and some form of restriction may be announced in the coming weeks. Tariffs on imports of Russian oil is one possibility to deter buying from the country.

With these two countervailing forces impacting oil prices at present, we believe it remains prudent to price in more upside risks than downside. The increasing restrictions in China have been occurring in tandem with the war in Ukraine and are responsible for a considerable amount of the easing in oil prices since the start of March. When a baseline level of activity in China materializes, the downward move in prices will halt or at least slow and any easing of restrictions will mean demand increasing in still tight market conditions, setting up a squeeze higher for oil prices. International pressure on Russia is also only likely to become more rather than less onerous, limiting its ability to export oil and products even if they are still carved out from sanctions. Even without the shock impact of EU sanctions for instance, Russian oil production has already begun to decline as buyers dry up while production increases from others, such as the rest of OPEC+ and the US, are coming onto the market incrementally.

We are maintaining our expectation for Brent prices at an average of USD 120/b and WTI at USD 115/b in Q2-Q3 when the tightness in markets will be more explicit. For Q4 we expect to see some easing back as economic activity starts to lose momentum as much tighter policy from major central banks has an impact on limiting demand.