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Eric Nuttall: The bullish supply-demand case for oil — looming recession aside

Prices have fallen 33%t since the summer

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Bruised by a 33-per-cent selloff in the oil price since summer and still suffering from recency bias inflicted by the COVID-19 pandemic, oil traders and energy investors alike are now gripped with a new fear: meaningful demand destruction resulting from a recession caused by rising interest rates around the globe.

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What would a recession mean for the oil price, and can investors simultaneously believe in the likelihood of one yet still be wildly bullish on energy stocks?

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Recessions do not always result in negative oil demand, and can equally lead to only a moderation in the rate of demand growth. Think back to the global COVID-19 recession of 2020, when we were locked in our homes, not driving for weeks at a time, and only military and cargo planes were flying, yet oil demand only fell by about eight per cent, demonstrating just how difficult it is to lower oil demand despite the most challenging economic environment in modern history.

Prior to this, the recession of 2009 induced by the great financial crisis, when the world’s entire financial system was hours away from ending, only led to a moderate two per cent decline in oil demand. And other recessions, such as in 2001 and 1991, had positive oil demand growth. What makes today’s setup so different to 2020 and 2009?

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The market is myopically ignoring several factors that could in aggregate fully offset a severe recession’s impact on demand and lead to an even tighter oil market in 2023: China is beginning to ease its COVID-19-zero policies that led to a drop in demand of approximately 0.5 million barrel per day; Europe is switching to oil from natural gas, which could boost demand by 0.7 million barrels per day; the Organization of the Petroleum Exporting Countries Plus (OPEC+) has a proven playbook to remove barrels from the market when there is a break between the physical demand for oil and the financial; there is an impending European Union ban on Russian crude oil imports on Dec. 5 that could finally result in a material hit to Russian oil production; and United States shale producers, the only source of short-cycle supply, are now beginning to set their drilling plans for the year ahead in the face of an oil price collapse.

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On top of that, energy investors already had a significant safety buffer to moderating demand growth. Despite the largest release from the U.S. strategic petroleum reserves (SPR) in history, originally aimed, at least officially, at offsetting a forecasted drop in Russian oil production that never really came, and China remaining under a state of suppressed oil demand due to COVID-19-zero policies, global oil inventories have continued to fall, indicating a persistently undersupplied market.

Global onshore oil inventories have fallen by 130 million barrels year to date, standing at a deficit of 221 million barrels compared to last year, according to Kpler Holding SA data, which uses satellites to track oil inventories in almost real time. But the 180 million barrels being released from the SPR ends in November, and there are signs that China has begun to ease many of its restrictions that have suppressed oil demand by approximately 135 million barrels.

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Furthermore, with European natural gas prices trading at a material premium to oil equivalence, as much as 700,000 barrels per day of fuel switching potentially exists, especially with the now zero chance of Europe importing further natural gas via the Nord Stream pipelines due to recent sabotage.

Combining the already undersupplied state of the oil market with these supply factors could alone offset any recessionary induced demand weakness, yet there are also bullish supply factors that are being overlooked.

First, OPEC is meeting this week to consider whether to cut production, which would act as a circuit breaker against further price weakness. A cut of one million barrels per day or more is quite possible, and would help narrow the vast difference between the physical demand for oil, expressed in falling inventories, and the collapse in the financial demand for oil, expressed in the 33 per cent drop in oil prices from earlier this year.

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Second, U.S. shale companies, coinciding with the historic volatility in oil prices and the growing uncertainty on 2023 oil demand, are now beginning to set their drilling budgets for next year. With production growth disappointing expectations so far this year, amounting to only 182,000 barrels per day from December 2021 to July 2022, the likelihood of continued production shortfalls owing to low-to-no growth budgets in 2023, especially with inflation of 20 per cent or more in service costs eroding spending power, has materially increased.


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The best setup for investors is when the oil price discounts the likely worst-case scenario, so they get free optionality on the current reality as well as the upside associated with better days ahead. That, in my opinion, is what energy investors get today.

Last week, Goldman Sachs Group Inc. in a report said that after the most recent price plunge, oil now discounts zero growth in global gross domestic product in 2023, something that has only been seen in the post-war era during the great financial crisis and the COVID-19 pandemic.

With the end to the largest SPR release in history next month, likely ongoing tepid U.S. shale growth, fuel switching, normalizing Chinese demand and the potential for a production cut that sends a signal OPEC will not stand idly by and watch the price of oil fall further, the case for a strong ending to the year and another great year for energy investors in 2023 is strong.

Eric Nuttall is a partner and senior portfolio manager with Ninepoint Partners LP. 
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