Oil Enters A Bear Market As Recession Fears Grow

For the second day in a row, oil and gas stocks emerged as the worst-performing S&P sector as U.S. crude oil futures settled in a bear market, falling more than 20% from a March peak on Wednesday. Front-month WTI crude closed -1% at $98.53/bbl, the lowest settlement in nearly three months and the second straight settlement below $100, while front-month Brent crude ended -2% at $100.69/bbl just a day after dipping below the psychologically-important level of $100/bbl for the first time since April.

Whereas Wednesday's decline looks tame in comparison to the previous day when both Brent and WTI collapsed nearly 10%, it extended the energy sector's losing streak and plunged it into bear territory for the first time in months. It has also reversed a recent trend where the sector was outperforming all other 10 market sectors to a situation where it's underperforming virtually everything.

The selloff has been so deep that prices have crashed all the way along the futures curve. For instance, Brent for December 2023 shed 8.8% on Tuesday to trade at its lowest level since March, almost as much as nearby prices. 

Market experts have interpreted the slide as a sign that some oil producers have been selling longer-dated contracts to hedge their supplies. Although such volumes have so far been rather modest, they can still compound the pressure on nearby futures.

Recession Fears

The funny thing is that this is all based on market sentiment and bearish projections but has little to do with the physical oil markets.

"A growing number of analysts are expecting that many of the world's leading economies will suffer negative growth in the next few months, and this will drag the U.S. into a recession," Fawad Razaqzada, market analyst at City Index, has told Bloomberg.

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Months of dwindling liquidity, alongside heavy technical selling as well as hedging activity by oil producers, have all contributed to the slide. However, the biggest driver has been concerns about a possible recession and an overly hawkish Fed, which have served to undermine the idea of oil prices being a means of hedging against inflation. 

"Recession fears likely pushed some investors out of the oil trade as an inflation hedge," Giovanni Staunovo, analyst at UBS Group AG, has told Bloomberg.

Last month, Federal Reserve officials determined to maintain an aggressive interest rate hike regime in a bid to cool down inflation and prevent it from becoming entrenched, even if that means slowing down the U.S. economy. According to minutes of the Federal Open Market Committee's June 14-15 policy meeting, the central bank plans to increase rates by either 50 or 75 basis points at its next meeting slated for July 26-27, hot on the heels of a 75-basis points raise in June--the biggest in nearly three decades. Indeed, it's June's massive hike that triggered the ongoing oil price selloff, meaning the oil bulls might not get a much-needed reprieve any time soon.

That said, the closely watched physical oil markets that give important clues to supply-demand trends have largely remained unchanged, with supply remaining tight and demand still high. Physical barrels are still fetching huge premiums over their benchmarks, so much so that Saudi Arabia recently lifted its prices to Europe to a record just hours before the plunge in futures. Meanwhile, prices of diesel and gasoline remain well above crude, giving refineries a big incentive to buy barrels.

If anything, the market appears bound to get even tighter, with Libya's output plunging and Kazakhstan's exports at risk. 

But that might only be the beginning of oil supply woes.

The U.S. and its allies could be about to engage in a dangerous move that might catapult oil prices to unchartered territory. According to Bloomberg, the allies have discussed a mechanism to cap the price of Russian oil at $40-$60/bbl in a bid to cut Vladimir Putin's revenue for the war in Ukraine.

However, such a move comes with the risk of Putin's retaliation, which could be catastrophic for the oil market.

Last week, J.P. Morgan Chase warned that global oil prices could climb to a "stratospheric" $380/bbl if G7 nations succeed in imposing caps on the price of Russian oil and prompt Vladimir Putin to inflict retaliatory production cuts.

According to JPM, Russia's robust fiscal position means the country can afford to slash crude output by as much as 5M bbl/day without excessively damaging its economy. However, such a drastic reduction would be very bad news for oil consumers as it would push Brent crude prices to $380/bbl.

"The most obvious and likely risk with a price cap is that Russia might choose not to participate and instead retaliate by reducing exports," "It is likely that the government could retaliate by cutting output as a way to inflict pain on the West. The tightness of the global oil market is on Russia's side," JPM  analysts wrote.

By Alex Kimani for Oilprice.com

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