History and geopolitics indicate the latter

The hottest month on record. Unprecedent wildfires in Europe, Canada and, most recently, the heart-wrenching devastation in Hawaii. Heavy downpours wreaking havoc in China, India and other parts of east Asia. Further escalations in the protracted war between Ukraine and Russia. A coup in Niger that has rocked the Sahel region in Africa. Growth uncertainty in top consumer China amid a series of disappointing economic numbers and bankruptcy filings by some corporate heavyweights. These are just a handful of the recent headline-grabbing developments the global economy is currently navigating. Any one of these macro or geopolitical topics would typically be enough to induce volatility in oil and gas prices as they would trigger demand, supply swings and trade flow uncertainty. And yet, the energy sector appears to be basking in the tranquility of a ‘Goldilocks Paradigm’.

Commodity markets have been relatively stable, partly helping tame the runaway surge in inflation to multi-decade highs witnessed through the second half of last year and early 2023. With US GDP posting a modest uptick, labor markets holding strong and broader financial indices remaining largely supported – all data points signal a resilient macroeconomic outlook, a far cry from a few months earlier when the Federal Reserve’s belt tightening measures led to growing concerns of the US economy sliding into a recession. The current set of favorable factors is partly feeding the energy market’s Goldilocks Effect: gas and oil prices remain relatively balanced, as supply chain bottlenecks get resolved and margins remain steady amid rangebound demand. The relative stability in the energy system through some truly cataclysmic events highlighted above, all within a tight span of the past few months, is remarkable. There are some industry-specific drivers that have partly contributed to the stability, such as oil production cuts by Saudi Arabia. Yet, a key question that can’t be brushed aside is: Can the stability be sustainable? Or is the energy system experiencing a calm before a storm – simply seeing balance before more volatility?

Beneath the calm, several potential disruptions could be converging that can disrupt this equilibrium. While the current state may seem like a perfect equilibrium, it is worth pondering whether this calm can be sustained. In this issue of our thought leadership series, we dive into the stability of the current energy landscape, examine the different potential storms the sectors are facing and probe the depths of a market that could be underestimating those risks.

The stability of the energy system goes beyond elements such as the ongoing summer heat, China’s real estate and macro-economic problems and Europe’s struggle with inflation. Other influences also hold substantial sway, often yielding short-term consequences that reverberate across the industry, like that observed last year with global supply chain disruptions that rocked the energy market dynamics.

Gauging the gathering storms: Disruptive geopolitical forces looming?

While market participants may appear to be casting aside concerns, it's vital to acknowledge potential short-term challenges. Let us first look into what could be argued as the most pivotal and far-reaching driver for energy markets: global geopolitics.

Some ongoing geopolitical tensions have been dialed down, though significant uncertainty still remains. It would be difficult to argue that the Russian war is not the largest unresolved geopolitical conflict impacting energy markets today. As witnessed last year, the war and ensuing trade tensions led to disruptions in the flow of energy resources, affecting both production and consumption patterns across regions.

Trade disputes at a geopolitical level can significantly reshape supply dynamics, while industrial action by labor unions, technology vulnerabilities, regulatory changes and other unforeseen events can each initiate short-term supply shocks. In the ever-evolving energy landscape, the potential for supply disruptions is not limited to natural disasters alone. A host of geopolitical, technological and regulatory factors can swiftly create disruptions, highlighting the need for a flexible and resilient energy infrastructure that can navigate those challenges.

Let’s also look at US-China tensions. Relations between the two superpowers have been steadily going downhill for some time now, with the rhetoric and public discourse increasingly getting more contentious. These two giants hold the power to significantly disrupt energy supply chains and have become entangled in complex trade disputes and strategic rivalries in recent years. Escalating tariffs, export restrictions and geopolitical maneuvers have the potential to cause ripples that reverberate through the energy sector well into the future. And this is no longer in the realm of possibility. Consider China's strategic decision to scale back photovoltaic (PV) exports, which has set off a chain reaction that is reverberating through the energy markets. A reduction in PV exports will alter the availability of renewable energy sources, affecting both the energy mix and market prices. As a major player in the renewable energy industry, China's policy shifts can impact global supply and demand dynamics.

In essence, the interplay of global geopolitics and energy markets is a complex dance of power, interest and influence. The volatility arising from tensions, conflicts and policy shifts underscores the need for market participants to adopt a nimble and adaptable approach.

China's influence: The ripple effect of economic uncertainty

China's growth trajectory has been a key driver of global energy demand growth over the past two decades. A rapid post-pandemic recovery – after the nation lifted its strict lockdown measures that were amongst the most stringent in the world – that was widely expected has failed to emerge so far on the back of successive forecast-lagging economic numbers. Measures by the central bank, such as lowering lending rates, have failed to revive investor confidence as domestic investments and exports slide, hurting overall manufacturing activity. Some of the deceleration could be tied back to the ongoing geopolitical tensions with the US, as companies remain wary of stepping up long-term spending in a nation that is looking increasingly prone to making unexpected policy changes relating to critical issues like technology transfer and exports. The widely held view – which played out remarkably well during the 2008-09 financial crisis – of China having enough policy tools at its disposal to bolster growth, given the dominance of state-run enterprises and its centralized governance system, hasn’t worked effectively so far. A potential slowdown in China's growth, which appears likelier by the day, would be particularly impactful. Such an event would lead to a downward correction in commodity prices, with decreased demand from the world's largest energy consumer. This would create a ripple effect, affecting not only the oil and gas sector but also global supply chains for other energy commodities. From coal to metals, China's influence extends to multiple facets of the energy market.

Yet, an unexpected resurgence in China's growth, if the government announces new stimulus measures, could have equally profound implications. A recovery in demand for energy resources would drive up prices, especially as Saudi Arabia remains razor-focused on making voluntary production cuts to create a price floor for offer. In addition, China's role as a significant player in the renewables sector means that changes in its growth trajectory could sway investments and innovations in the clean energy space.

Energy market participants are keeping a close eye as China's economic trajectory wobbles, mindful of the potential domino effect that changes in the nation's growth could set off. The interplay between the Asian giant’s economic fate and the global energy landscape underscores the interconnectedness of today's markets.

An uncertain recovery in Europe: Navigating economic fragility

Beyond China, the economic outlook in Europe will also play a key role in influencing energy markets in the months ahead. Europe's fragile economic recovery is getting weighed down by persistent inflation, which is prompting steady interest rate increases, posing challenges for a soft landing. Uncertainties surrounding how these factors will impact demand and trade dynamics and influence energy markets. Europe's economic landscape remains complex and likely has a delicate recovery journey ahead, marked by several factors that could potentially influence energy markets. A stubbornly high inflation might erode purchasing power, reducing energy consumption, while tightening monetary policy to fight it could severely reduce economic growth and profitability, pushing the region into recession. These interactions complicate global energy market scenarios, affecting both the traditional and renewable markets. How these dynamics play out in the coming months and years will undoubtedly shape the energy landscape, as businesses and policymakers alike adapt to a shifting economic backdrop.

Macro influences on oil, gas and supply chains

Oil markets are currently being torn by two almost equally powerful forces. China’s perceived slowdown, concerns over which have gained momentum in the past three months, and Saudi Arabia’s determination to offset signals of demand weakness coming from China through voluntary oil production cuts. So far, the Saudis appear to be enjoying the upper hand. By cutting 1 million barrels per day (bpd) of production since July, it has more than compensated for the relative weakness in China, allowing global inventories to drop and ensure the emergence of a steeper backwardation in the Brent and WTI forward curves. As a result, crude spot prices have increased from the low $70 per barrel range since July to the mid-$80 per barrel mark at the time of writing. Without the Saudi cuts, crude forward curves would have remained flat or gone into contango.

But here lies an important caveat: Saudi Arabia has managed to keep oil prices high because oil demand has only budged marginally. Since May, China’s road transportation consumption has decreased steadily, but global oil demand elsewhere has remained resilient. What if China was going into a more severe slowdown? It appears unlikely that Riyadh would want to drop production below the current level of 9 million bpd, thus limiting the power of its ‘put option’ on the market.

And what about aviation? More than half of the 2023 oil demand growth, which is expected at 2.1 million bpd, is being driven by aviation. The sector has been blighted by supply chain issues for the past three years, although consumers so far appear very eager to resume their pre-pandemic travel habits. Even so, how would steady increases in fare prices impact travel? Currently, flying from the US to Europe costs significantly more than in 2019 – prompting the question on the sustainability of the recovery in aviation. Yet, year-to-date jet fuel demand is up about 1.0 million bpd since last year. So, while Saudi Arabia has played its cards really well so far, demand-side risks could overwhelm this strategy in a matter of few months.

Meanwhile, this past month was the hottest on record and while this has certainly accentuated natural gas demand for cooling, unwavering energy markets seem to have taken little notice of the surge in northern hemisphere summer demand this year. Global gas markets have softened even though demand has expanded, which is due to the bloated storage levels that are keeping prices in check. In the US, storage injections in the short term are expected to fall, indicating tightening fundamentals. Still, even with the reduced gas storage injections from recent weeks, robust gas production in the US has helped stabilize Henry Hub prices. They are likely to remain rangebound, with little upside until the end of injection season. While it seems the challenging volatility of the past few years has passed, any of the conditions discussed above, or a combination of them, could invite instability, shifting market dynamics toward significant price surges.

For the oilfield services sector, a significant contraction in drilling and completions activity in the Lower 48 has led to service price deflation and easing of supply chain bottlenecks that had plagued the industry these past few years. Operators have hit the upper end of their production guidance due to improved efficiencies and from being laser-focused on sticking to their capital expenditure (capex) guidance. They have resisted the temptation to add rigs and fleets despite seeing higher oil prices and lower service costs. Service companies have been able to hold on to their margins so far but will likely take a moderate hit in the coming months should activity stay at current levels. The market remains in an interesting state since activity is still contracting while macro oil and gas fundamentals warrant a step up in operations. There is typically a lag of about three months for higher commodity prices to reflect on activity. With commodity prices remaining favorable, a softer second half could result in a decent uptick in activity early next year, as budgets get reset.

 Anticipating the unpredictable

Amid this uncertain calm, contemplating possible scenarios reveals the unsteady equilibrium of energy markets. We consider the emergence of two contrasting landscapes that could destabilize the current equilibrium:

In the ‘new normal’, despite numerous headwinds, the energy market remains bound to a narrow trading range. Even so, we struggle to believe that a newfound stability has emerged – and as history shows, energy markets have been anything but stable for long. That leads us to a scenario we consider to be more likely, dubbed a ‘fragile balance’ – the headwinds we currently face could evolve into disruptive forces capable of upending the status quo. The notion that this equilibrium might crumble is a stark reminder that the most tranquil periods usually do give way to upheavals, as history of the oil price implied volatility index reminds us (See below)

While the markets may be thriving, the undercurrents of uncertainty, be they geopolitical tensions, supply chain vulnerabilities or changing climate patterns, could all lead to tumultuous shifts. As the sector grapples with the question of whether the Goldilocks Paradigm is truly stable or inherently unstable, the message is clear: energy market participants must remain vigilant, nimble and ready to weather the storms when the time comes. If history has taught us anything, it is this – a storm will come eventually, it is just a matter of being prepared and ready to adapt to the unforeseen events that come with it.

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Authors: 

Claudio Galimberti  

Senior Vice President of Oil Markets, Head of Americas Research 
claudio.galimberti@rystadenergy.com

Emily McClain

Vice President of North America Gas Markets Research 
emily.mcclain@rystadenergy.com 

Thomas Jacob

Senior Vice President, Supply Chain Research
thomas.jacob@rystadenergy.com

Manash Goswami

Vice President, Analytics
manash.goswami@rystadenergy.com

(The data and forecasts contained in this column are Rystad Energy’s and the opinions are of the authors.)