As the War Risk Premium Fades, other Economic Concerns Surface

After the brief surge in oil prices we saw in October, prices have faltered. The oil prices have been taking a steep dive to new lows over the past 3-month period. In the last 4 weeks alone, we have witnessed key benchmarks in oil pricing such as the West Texas Intermediate (WTI) and Brent Crude, falling over 11% and 8% respectively. 

There may be several factors which play into this: one of which being the input of the Israel-Hamas conflict. After Israel declared war on Hamas following the attacks of October 7th, there was a frenzied price surge in oil. With so much unrest on the front doorstep of major oil producers including Saudi Arabia, the UAE, Kuwait, Iran, and Iraq; global disruption of the production and export of oil is a possibility. Evidence of this was the brief price spike with WTI flirting with $94 per barrel shortly thereafter.  

With the sudden increase in oil prices, many have turned to the financial derivatives market to hedge against rising prices. A prime example of hedging against oil prices can be seen via airline companies, as one of the posing threats they face are rising fuel costs. The options market specifically, saw a surge in call options being used as a form of protection against the threat of rising oil prices. A buyer of a long call option has the right but not obligation to buy the underlying asset at a predetermined price of X, over a set predetermined period, for a premium upfront. The heightened demand for the calls drove up the cost, and on the rare occasion out pricing the bearish put options. However, despite being over a month into the ongoing conflict, oil prices are hitting new pre-Israel war declaration lows. Interestingly, the previous high cost associated with the bullish call options on crude, now falters compared to the price of puts, which once again exceeds the calls in terms of option pricing. This further demonstrates market expectations of the Israel-Hamas conflict to remain limited to a specific region, despite heightened risk of a broader scheme conflict. Israel and Gaza yield little oil production, and surrounding countries remain undisrupted, leading us back to the further diminishment of the war risk premium. 

As the war premium fades into the background noise, a new fear presents itself. All eyes focus back to the outlook of oil, with the current concerns of oversupply and weak demand. Europe continues to be in an energy crisis, the U.S. hitting record numbers of oil production, and weak demand stemming from China, all these factors (amongst many others) tie into a very intricate set of circumstances revolving around geopolitical turmoil. 

On one end of the spectrum, U.S. oil inventories and production have been experiencing continuous increases in recent weeks, hitting record high numbers. Something noteworthy to bear in mind, is the carrying costs associated with the storing of physical oil barrels which can pose a threat. The cost of financing and storing oil barrels in large warehouses that frequently require ongoing maintenance and incur various other operational expenses. This becomes quite costly – especially at the fatal death grip of record high interest rates over the past 22 years. The repercussion of this is there is now a high incentive for those who are storing large quantities of oil to begin indulging in a sell off, as the price of holding proves to be high.

Stuck in the middle you have beautiful Europe amidst an energy crisis. An example being Germany, now having been in recession for three straight quarters. Prior to Russia’s invasion of Ukraine, Germany amongst many others in the EU, had a particularly heavy reliance on Russian energy. Due to the EU finalizing the decision to cut Russian energy imports, Europe now turns to the Americans as a new energy supplier - for a new price. Larger European economies such as Germany and France demanding less oil and experiencing negative economic effects, could prove to have ripple effects throughout the larger European region. 

Lastly, you have China.

Being quick to replace European imports of Russian oil and natural gas, China takes the throne of being Russia’s number one buyer of crude at steep discounts. Even with the access to cheap energy, there are growing concerns regarding China’s consumption. The downturn in refining margins and an increase in crude stockpiles, points to lower domestic demand and consumer confidence. To add more fuel to the fire – China being the largest buyer of oil from Saudi Arabia, has requested less supply for the month of December, sparking further concerns regarding oil demand outlook.

Despite the ongoing geopolitical tensions, the focus now turns  to internal challenges such as the oversupply, Europe’s energy crisis, and weak demand. The market remains on the tightrope, underlined by very complex, intricate variables. As the war risk premium diminishes, the outlook of the industry grapples with uncertainties tied to economic recession, a push for renewables, and shifts in regard to geopolitics and consumerism. All of this further emphasizes the importance of adaptability to navigate the sophisticated landscape of the oil market.