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Could crude oil prices go down to $40?

Return of volatility provides an overdue reminder of global supply and demand uncertainty

As financial market volatility sparks oil price selloff despite strong China demand, oil market analysts expect the contagion to entrench deeper and longer into the physical economy, cutting consumer spending and knocking oil demand hard. Some analysts even predict that if the current troubles infect the entire regional banking system, Brent could go as low as $40.

They said that the return of oil market volatility provides an overdue reminder of the uncertainty surrounding global supply and demand dynamics. The collapse of the Silicon Valley Bank has exposed cracks in the global financial system, sparking a market sell-off that pushed oil prices down to their lowest levels in well over a year.

Days after the collapse of SVB, Credit Suisse was forced to announce a facility to borrow up to $54 billion from the Swiss central bank in a bid to calm investors after a sharp drop in its share price.

Markets finally broke out of their range-bound trading last week amid major banking-sector concerns. Having been locked into an $80-85 per barrel range since the start of 2023, prices broke to the downside with West Texas Intermediate crude futures, the US benchmark, falling as low as $65.89 per barrel on Monday, down almost per cent from Thursday’s settlement levels. Brent crude, the international benchmark, fell almost as badly, to $72.10 per barrel. Both benchamrks hit their lowest in alost 15 months.

Analysts are increasingly convinced that bearish economic forces are outweighing the bullish impacts of China’s rebound and sanctions against Russia.

Natasha Kaneva, the head of global commodities research at JP Morgan, wrote in a report that the oil market would remain in surplus over the next two months with oil prices under fundamental pressure through May as global inventories likely swell by another 46 million barrels.

She thinks it is less likely that prices climb back in the near term and sees prices trading between $70 and $80, unless one of two things happens.

The first catalyst for the price surge would be a change in strategy by Opec, which has stuck to a production schedule it laid out in October 2022. There is a chance the group decides soon to make further cuts. In such a scenario, Kaneva thinks the group could cut quotas by about 400,000 barrels a day, a small but significant piece of the 100 million barrel daily oil market.

The other catalyst would be an announcement by the US government that it will start refilling the strategic petroleum reserve (SPR), which is at its lowest level in decades. Large oil purchases by the government would likely cause prices to rise.

However, in the absence of those two catalysts, oil price trends may depend on the shape of the banking turmoil. If things get worse, prices would fall precipitously, because recessions caused by a financial crisis tend to be two to three times worse for oil than other recessions, they warn.

“Historical analysis shows that contagion in financial markets tends to entrench deeper and longer into the physical economy, cutting consumer spending and knocking oil demand hard,” Kaneva wrote. If the current troubles infect the entire regional banking system, Brent could go as low as $40, she said.

Globally, 120 million barrels of oil have built up in storage over the past three quarters as supply outpaced demand. Even with China reopening, analysts don’t expect the balance to shift for months.

“The underlying fundamentals aren’t as terrible as what is being priced in here, but there is concern the oil is not as safe a place as cash or gold,” said John Kilduff, partner at Again Capital in New York.

Analysts still expect constrained global supply and China’s demand recovery to add price support in the foreseeable future.

Opec sources also believe that the current price weakness was caused by financial drivers rather than any supply and demand imbalance and expect the market to stabilise.