Are Oil Prices Actually Disconnected From Fundamentals?
Parameterizing the increasingly common argument that prices no longer reflect fundamental market realities.
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A growing number of analysts—and OPEC ministers—claim that prices have become disconnected from fundamentals; but are they, really?
On the contrary, prices appear well in line (in the mid-70s) with their historical relationships to commercial inventories, arguably the most “fundamental” of fundamentals.
The ill-conceived commingling of commercial inventories and SPR volumes for the purposes of price modeling further exacerbates the sense that prices have become untethered from crude-related realities.
The more accurate statement is that prices don’t seem to be pricing in forecasted fundamental tightness over the coming half-year—but is this even all that surprising given last year’s mother-of-all consensus outlook misses?
My view is that the market is going to require tangible and sustained inventory draws—show me the money!—before prices durably rally higher once again.
Prices are disconnected from fundamentals; this is an increasingly common refrain that we’re hearing these days from analysts, media commentators, and policymakers across the oil industry. I, myself, have repeated a similar sentiment multiple times over the past half-year, complaining of the inescapable range-trade and the outsized impact of broader market sentiment compared to crude-specific developments—and, just maybe, you’ve said it too.
But now, I’m finding myself increasingly uncomfortable with the liberal use of this disconnect stroke. Specifically, I take issue with the implication that crude, today, should be back above $80, $90, or even $100 a barrel because of “fundamentals”, which is, I believe, a vast overstatement. This sentiment was particularly palpable through the latest OPEC+ meeting and surrounding commentary, with the Saudi Energy Minister explicitly stating that current prices do not reflect the physical market and OPEC is “working against something called uncertainties and sentiments” with their latest cuts.
Quite to the contrary, my inventory-only model—as you can see in the above chart adapted from How Do Oil Inventories Drive Crude Prices?—puts the appropriate price for Brent crude in the mid-$70s, which is more or less exactly where it stands today. So, while the intra-week chop certainly feels more so driven by speculative flows and macro panic, the rough level around which we’re seeing said chop feels, actually, quite reasonable given known and realized fundamentals—like inventories.
In this post, I want to review some of the ways that oil prices can “disconnect” from fundamentals to provide more context for debating and assessing the state of the crude market. Ultimately, I am proposing that what many people are sensing is that current pricing doesn’t seem to be internalizing the “consensus” outlook for oil supply-demand balances. And I think this is a fair argument; indeed, it may turn out to be true. But, it isn’t the same argument—and your uncertainty about the future should always remain higher than about the past. Not to mention how the recent SPR releases have further distorted our current view on the relationship between inventories and prices.