Oil Market Tightens but China Looms Large

The oil market tightened in the past month. Improved macroeconomic conditions have boosted the demand outlook for the coming year, and supply cuts from the Organization of the Petroleum Exporting Countries and allied producers (OPEC+), especially unilateral cuts by Saudi Arabia, are beginning to bite. The International Energy Agency (IEA) estimates that oil demand reached an all-time high in June at 103 million barrels per day (b/d), and front-month Brent crude prices hit $85 per barrel in late July. The White House may be alarmed by the prospect of rising gasoline prices. Still, the outlook is not uniformly bullish. Economic risks in China are mounting, peak summer driving season in the United States is ending, and non-OPEC supply has been more resilient than many anticipated.

Since the Federal Reserve began to hike interest rates in March 2022 to contain inflation, the oil market has been preoccupied with risks to growth in advanced economies. The market seemed fixated on negative economic news, such as the short-lived financial sector distress this spring that led to a sharp price decline. Persistent bearishness frustrated OPEC+, which cut production in October 2022 and April 2023 but seemed unable to regain the upper hand. Saudi energy minister Abdulaziz bin Salman repeatedly argued that “speculators” were ignoring market fundamentals. Even when Saudi Arabia announced a 1 million b/d unilateral production cut beginning in July and extended it for August and September, the market was slow to respond.

Oil market bulls view the past month as an inflection point. Brent crude broke out of its slump, with market participants eyeing better economic prospects with the potential tapering of Fed rate hikes, as well as likely supply deficits late this year. OPEC+ cuts are an important catalyst. Saudi Arabia’s crude production dropped to about 9 million b/d in July, according to most estimates—its lowest monthly volume since 2021. Supply cuts from Middle Eastern producers have created an especially tight market for sour crudes, boosting prices.

China was the key uncertainty in oil demand this year, and after several years in which Covid-19 restrictions cut domestic transportation and industrial activity and curtailed demand, it staged a strong recovery in the first half. Apparent oil demand rose by 11 percent, with robust gasoline and jet fuel consumption. Inventory builds probably strengthened China’s crude imports as it sought to take advantage of lower prices.

However, China’s macroeconomic signals are looking decidedly weaker, and it will be hard for oil demand to continue outpacing economic growth rates. Ongoing weakness in the property sector, as well as poor consumer sentiment, are dragging down industrial production and retail sales, and China’s central bank has cut several key interest rates to rekindle growth. The real estate slowdown underscores that China’s post-Covid-19 economy may look quite different, with slower growth rates and less commodity-intensive sources of growth. Even if its citizens drive and fly more, weaker industrial activity will curtail demand for diesel and petrochemicals.

Seasonal demand in the United States may have contributed to the recent price bounce, but the peak driving season is winding down. U.S. gasoline demand has been relatively strong in recent months, although implied demand tailed off in early August. Support for structurally higher oil prices still depends largely on demand in non-OECD countries, where the IEA forecasts 2.1 million b/d of demand growth in 2023 compared to just 123,000 b/d for wealthier countries.

There have been several surprises on the supply side. Following production cuts by Saudi Arabia and other producers, OPEC+ output fell by nearly 1 million b/d in July, and the Saudi cuts will have a similar impact in August and September. But non-OPEC output has been surprisingly resilient this year, with growth in the United States, Brazil, Guyana, and other countries. Despite perpetual chatter about “peak shale” and barriers to investment in the United States, oil production is growing, albeit at a more moderate and more sustainable rate as capital discipline reigns. The U.S. Energy Information Administration (EIA) pegs U.S. crude oil production in July at about 12.7 million b/d, or nearly 900,000 b/d in year-on-year growth—despite the fact that the North American rig count has dropped steadily since last December. Russian production has also remained resilient, although export declines are starting to set in. Russia pledged to cut oil exports by 300,000 b/d in September, following promises to cut exports by 500,000 b/d in both July and August. Its crude exports began to fall last month, although it is likely that domestic refinery runs will increase and the country will ramp up product exports instead.

Where does this leave market balances? Most analysts agree that the market is headed for a supply deficit in the fourth quarter of 2023, but the scale of the shortfall is uncertain. The EIA estimates a modest supply deficit of about 230,000 b/d in the fourth quarter. The IEA expects a wider deficit, based on its strong demand forecast for China. But the Paris-based agency expects petrochemical feedstocks to account for more than half of China’s anticipated 1.6 million b/d in demand growth this year. Economic challenges in China could weaken demand for those products in the fourth quarter and into 2024.

Saudi Arabia, the United Arab Emirates, and others likely believe that production cuts are starting to deliver the desired results. But if China’s growth disappoints in the second half, there are few remaining engines of oil demand. Saudi Arabia and other major producers will likely extend their cuts if they see downside demand risks accumulating in China.

Rising U.S. gasoline prices over the past six weeks are no doubt attracting some attention at the White House. A continued oil price run-up into the fall would strengthen calls for OPEC+ to add supplies to the market, and perhaps for domestic companies to increase upstream investment. But for now, an overheated market in the fourth quarter is possible, not inevitable.

Ben Cahill is a senior fellow with the Energy Security and Climate Change Program at the Center for Strategic and International Studies in Washington, D.C.