Oil: From sizzle to fizzle

Izzet Yildiz, Ph.D., Analyst, 02/10/22


  • Tensions in Eastern Europe and the global energy crunch have lifted oil prices higher.
  • Oil has overshot our fair value estimate of $75 a barrel due to demand expectations.
  • A nuclear agreement with Iran could lift sanctions and allow it to export more oil.
Oil prices have rocketed to seven-year highs due to supply disruptions, rising demand, geopolitical tensions between Russia and Ukraine, and the cold snap in the United States. Futures for West Texas Intermediate (WTI), the U.S. benchmark, surpassed $93 a barrel over the last week, the highest since 2014. Brent crude futures, the benchmark in energy markets, also rallied above $93 a barrel in early February.

But we see risks to the rally because current prices are unsustainable. As such, we have a bearish view on oil over the short and long term. We expect WTI prices to drop to around $75 a barrel by the middle of 2022, with a risk of a deeper correction to $60–$69 a barrel.

Freezing weather and Russia–Ukraine crisis blur outlook

Oil prices have overshot supply-demand fundamentals and the physical market dynamics. Among the factors driving the rally are concerns that tensions in Eastern Europe will spill into energy markets by denting supplies from major crude producers. Other contributing issues are bottlenecks in global oil supply, frigid U.S. weather, and expectation from traders that strong demand will recover this year.

January was colder than normal in the United States, fueling supply fears that winter storms could cause a temporary shutdown in production. The chill has lifted demand for U.S. oil products at the start of this year to the highest levels since 2010, according to data from the U.S. Energy Information Administration. This demand is largely for distillates for heating fuel and for oil amid disruptions in natural gas productions in Texas. Gasoline demand is weaker than the 10-year average. In our view, extreme temperatures are a temporary winter phenomenon.

Another factor is the geopolitical risk premium attached to oil prices. Markets are worried that the standoff between Russia and the West over Ukraine could lead to sanctions on Russia. We think Russian President Vladimir Putin is bluffing about a full-scale war and sanctions are a tail risk. While we can’t ignore these risks, an invasion is unlikely to affect oil supplies. Russia produces about 12% of global oil. It will be difficult to sanction “Russian oil.” We believe western leaders can’t afford such an oil shock because higher prices may prove to be unpopular for political reasons. For the West, Ukraine may not be worth more than winning elections, in our view.

Tempering market expectations

Supply disruptions — which amounted to about 1 million barrels per day in January — also pushed oil prices higher. The shortages included about 500,000 barrels per day (bpd) from Libya, 200,000 bpd from Nigeria, and 300,000 bpd from Ecuador and other producers. These supply constraints have been fixed, and production has recovered in these regions.

Another factor affecting oil is the bullish demand expectations from crude markets and refineries. Betting on rising demand, refineries are buying cargo for delivery for March and April. But the question remains whether the recovery in global demand will continue at the same speed and match expectations from refineries and suppliers. Diesel demand rose above pre-pandemic levels at the end of 2021. Gasoline is currently at pre-pandemic levels. But jet fuel, which accounts for about 7%–8% of the overall demand for crude products, is at about 80% of pre-pandemic levels. Given this backdrop — along with slowing growth in China and higher interest rates — we don’t expect higher levels of recovery.

And finally, we must look at Iran’s spare capacity. Iran’s nuclear negotiations resumed this week in Vienna. A nuclear deal could restore the Persian Gulf nation’s sanctioned oil to world markets. Russia has indicated that an agreement could be reached by the end of February, but the United States is more cautious. We believe talks over reviving a nuclear agreement with Iran will take time. The diplomatic signs point to the Biden administration striking a revised deal. That could lead to Iran supplying an additional 1.5 million to 2 million barrels of oil a day to global markets.

Finding the fair value

Many of the factors mentioned above are temporary and will fade over the coming months, in our opinion. Moreover, expectations for demand growth are too optimistic, and oil markets are ignoring the potential upside in supply, in our view. Our fair value model for oil shows $75 a barrel for WTI over the short term. But prices have already overshot this level. The rally could continue for a while before prices converge to the fair value.

U.S. crude has surpassed the fair value estimate

(US$ per barrel, daily)

Oil fair value

Sources: Bloomberg, U.S. Energy Information Administration, and Putnam Investments calculations as of February 7, 2022.

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