Oil markets are kicking off the new year under heavy selling interest with crude futures down over 10% this week. On the back of the more than 40% bearish reversal seen from last year’s highs, traders are questioning whether the downtrend is likely to continue over the early part of 2022.
To answer this, let’s consider the factors driving the oil markets currently and how they look set to develop over the coming months.
Key factors driving oil market
- China / covid
- US rates / global recession risks
- Russia – Ukraine war / supply expectations
China / Covid
While there are a few key factors to note, the biggest issue for oil currently is the covid crisis in China. The reversal of the government’s zero-covid policy was expected to drive a huge boom in demand. However, with the country now facing a soaring covid crisis oil prices have plummeted as demand outlooks are revised lower. Along with huge disruption to consumer and industrial demand, record covid levels in China are driving a fresh global response in terms of travel restrictions, dampening travel demand and further weighing on oil prices.
The major fear, in light of record infections and deaths, is that the government will be forced to reintroduce lockdown measures leading to similar conditions as those in Q1 2022 which drove oil prices sharply lower. Given the importance of the Chinese economy to global oil demand, the current situation is extremely worrying and traders are monitoring incoming data and headlines eagerly.
US rates / Global recession risks
US rate projections and global recession risks are also being closely monitored. Ahead of the December FOMC, traders were anticipating a full dovish pivot by the bank, paving the way for risk assets to rebound as the Dollar came off. However, while the Fed pivoted on rates as expected, the accompanying guidance and rate projections were more hawkish than many expected. The Fed lifted its peak rate projections, arguing that rates need to be at higher levels for longer in order to bring inflation down.
The outlook for higher rates for longer in the US is adding to global recession fears. With rates at elevated levels across the globe and with inflation still rampant, the growth outlook for 2023 has been slashed across the board. With activity and trade set to weaken, OPEC and the IEA have both lowered their demand outlook for the year ahead.
Russia – Ukraine war / Supply expectations
Finally, the war between Russia and Ukraine is a further ongoing factor to monitor. The initial upward shock in prices has dissipated as governments in the West have sought to substitute Russian supply elsewhere, including a ramping up of production in the US. The US government has been actively engaged in trying to drive down the price of oil to help curb the harsh impacts being felt across the US economy.
Q1 Outlook: base scenario & risks
Looking ahead for Q1 then, the base case scenario for oil is that prices continue to weaken near-term. The China story has plenty of downside risks in it as discussed. Should we see a return to lockdown, this will be a heavy bearish development for oil prices. Additionally, with fears that a new variant might see a return to pandemic-era restrictions globally, oil demand looks subject to further deterioration.
However, as we move through the quarter, risks are likely to flip to the upside. Should the situation in China come under control and start to improve, this will lead to a quick repricing of oil demand expectations with the focus switching to a full reopening of the economy into Q2. Additionally, should US inflation start to cool ahead of projections, this will likely fuel a shift in market expectations with regard to Fed rates this year, weakening the Dollar and driving commodities higher.
Finally, EU sanctions against Russian oil alongside any further OPEC production cuts, has the potential to flip the market into a deficit which should again fuel a lift in prices. With this in mind, the outlook is: remain cautiously bearish for now but on the lookout for a change in the current narrative. Given that oil positioning has been at fairly constrained levels for some time, there is plenty of money to come to the table to drive a reversal if conditions are correct.
Technical views
Crude oil chart (weekly)
Source: TradingView / FlowBank
Oil prices continue to trade lower within the corrective bear channel which has framed the reversal from last year’s highs. The market is currently trading within the bottom half of the channel but is above the 67.42 level support for now. A break below here will open the way for a test of the 53.90 level next. Bulls need to see a break of the local channel top and 93.72 highs to affect a bullish shift in sentiment.
