Oil prices fell sharply in May and are now trading at below fair value amid concerns about tariffs and weaker global growth.

Oil prices fell sharply in May, tracking the downward trend in risky assets. Prices dipped lower on fears that rising trade tensions will weaken the global economy and hurt demand for oil. The U.S. Department of Energy's inventory report showed a sharp increase in inventories. That has puzzled many analysts since the figures for reported inventories do not match those implied by production, exports, and imports. We note that there are discrepancies in data, and for the most part we assume these "errors and omissions" cancel out over time. Still, these inventory issues are large.

Saudi Arabia is offsetting the weakness among the Organization of the Petroleum Exporting Countries (OPEC) by increasing output.

There has been no major change in supply and demand dynamics. Exports of oil from Venezuela and Iran continue to decline. Saudi Arabia is offsetting the weakness among the Organization of the Petroleum Exporting Countries (OPEC) by increasing output. Problems with Russia's Druzhba pipeline surfaced in late April, when crude in the line was discovered to be heavily contaminated with organic chlorides. The issues affected prices for Brent, the global benchmark for crude. Russia is still struggling with the contamination problem and has recently been producing a little less than 11 million barrels per day — slightly below its quota under the OPEC+ coalition deal (OPEC+ refers to non-member countries such as Russia). So, for now, there continues to be supply discipline on the part of the major producers.

On the demand side, there are a few hints of weakness. Refinery runs in Europe are down, and the Russian oil contamination remains a problem. Demand for diesel in the United States seems to be a little weak, but at least this, in part, reflects the floods in the Midwest and major delays in the planting session. Fewer tractors chugging up and down fields at a time when there is a substantial seasonal peak in agricultural demand will disrupt the seasonal adjustment factors. There are also signs of some weakness in demand from Asia.

Fair value drifts lower in 2020

Prices have fallen below what we think is fair value given trends in supply and demand. We forecast that the fair value estimate for oil will move lower later this year. Obviously, this requires assumptions about trends in supply and demand. The gentle drift down in prices signals three things.

Crude oil's fair value

First, it's hard to see what would push oil prices significantly higher than the current fair value. Still, in the near term, anything can happen, and an event like a war in the Middle East would have a major impact. The attacks on two tankers in the Gulf of Oman in June have sent the United States and Iran, two longtime adversaries, careening toward potential crisis. But short of this type of disturbance, there is enough capacity around to ensure a cap on prices. Second, OPEC+ discipline imposes a burden on Saudi Arabia. Russia has recently indicated that it expects to keep cooperating with OPEC, but that the Saudis want a higher price than Russia feels it needs.

Currently, we don't have a U.S. recession in the forecast, but the risks of a worse outcome are rising.

Risks of a steep decline in U.S. growth are rising

Internal disputes have caused troubles for OPEC in the past and could do so again. U.S. sanctions on Venezuela and Iran have had the effect of making OPEC discipline easier to maintain, but that doesn't mean we can rely on discipline to continue indefinitely. The third factor is demand. As we mentioned earlier, the global economy is slipping a little, and the risks seem to be to the downside. If the economy weakens further, oil demand will be affected. Currently, we don't have a U.S. recession in the forecast, but the risks of a worse outcome are rising.


More from Macro Report
Download the Macro Report (PDF)

The global economy has weakened a little and asset markets have tumbled because of the United States' trade disputes with China and other nations.