Will international oil prices enter a downward channel?

On July 12, international oil prices suffered another heavy blow, collectively losing $100 per barrel
.
Both Brent and WTI fell more than 7% intraday, with Brent September crude oil futures trading at $99.
49 per barrel and WTI August crude oil futures trading at $95.
84 per barrel
.

On July 5, Brent and WTI crude oil futures prices fell the most since March, and continued their downward trend on the 6th, both falling below $100 per barrel
.
According to the closing price of the first contract, it is down more than 20% from the highest closing price of the year on March 8, which is considered to have technically fallen into a bear market
in international oil prices.

Meanwhile, Citibank and Goldman Sachs released very different research reports
.
Citibank expects that in the event of a recession that severely affects demand, Brent crude could fall to $65/barrel by the end of the year; Goldman Sachs expects that although the possibility of recession is rising, the decline in demand is not enough to change the state of insufficient supply, and international oil prices are expected to reach $140 / barrel, and if global crude oil production is significantly reduced, international oil prices may even reach $380 / barrel
.

Will international oil prices rise, or will they enter a downward channel? This paper analyzes
the formation mechanism of international oil prices, the reasons for the decline in oil prices, and the factors affecting the future market.

How are international oil prices formed?

Generally speaking, international oil prices have gone through three stages
in history: monopoly pricing, equilibrium pricing of supply and demand, and trading pricing in the futures market.
Among them, monopoly pricing refers to the "seven sisters of oil" period, seven international oil companies with monopoly positions in the international market negotiated pricing through cartel, set lower export prices in exporting countries, and set higher consumer prices in consumer countries to obtain monopoly profits
.

Supply and demand equilibrium pricing refers to the pricing method in which after the establishment of OPEC, its member countries have established a pricing method
that targets demand and adjusts crude oil production to maintain the basic balance of supply and demand in the international market through the implementation of production quotas.

Futures market trading pricing refers to the 80s of the 20th century, after the New York Mercantile Exchange and the London Petroleum Exchange successively listed WTI crude oil futures and Brent crude oil futures, with the development of the futures market, the activity of crude oil futures gradually increased, and the futures price was widely accepted by real enterprises, resulting in OPEC under the leadership of Saudi Arabia to finally change to be linked to the trading price of Brent or WTI crude oil futures to determine the international market sales price
.
At present, Brent crude oil futures have become the world's most influential pricing benchmark, which is widely used in international oil trade, as well as the pricing
of some international natural gas trade.

It is worth noting that in the crude oil futures market, the structure of traders and trading methods have undergone profound changes compared with the initial period, the trading volume of non-entity enterprises such as various funds and investment banks has far exceeded the trading volume of real enterprises in the oil industry, quantitative trading is becoming the mainstream trading method, the total trading volume of crude oil futures far exceeds the global crude oil production and trade volume, and the financial attributes of the crude oil futures market are becoming stronger
and stronger.
Therefore, in the current composition of international oil prices, it can be decomposed into four parts
: basic price, financial premium, geopolitical risk premium and phased change price.

The basic price refers to the price determined by the specific supply and demand relationship in the international entity oil trade, that is, the price
determined by the equilibrium relationship between the actual production or supply of crude oil and the actual demand starting from the supply and demand of crude oil.
This is also the equilibrium price
of supply and demand discussed in the traditional pricing theory of Western economics.

Financial premium refers to the part
of crude oil trading price changes under the role of crude oil futures market, affected by future supply and demand changes and changes in capital trading volume in the crude oil futures market.
For example, the expectation that future demand will grow faster than supply will lead traders to expect crude oil prices to rise, and more traders will open long positions; Conversely, traders expect crude oil prices to fall, and more traders close their long positions and open more short positions
instead.
Once this expectation becomes the expectation of most traders, it will contribute to the formation of an uptrend and further push up or suppress the trading price
.
For example, when the US monetary policy is in an easing cycle, it means that the cost of obtaining US dollar funds will gradually decrease, and traders can use the leverage mechanism formed by the margin of futures trading to increase trading volume; When monetary policy is in a tightening cycle, the cost of capital tends to rise, which will suppress trading volume
.
In fact, the financial premium stems from the trading risk in the crude oil futures market, and the stronger the speculation atmosphere, the higher
the financial premium.

Geopolitical risk premium refers to a sharp change in the supply and demand relationship in the crude oil market due to sudden geopolitical risk events, or the expectation that the supply and demand relationship will change dramatically as the event unfolds in the future, resulting in changes in crude oil prices
.
The UAE energy minister believes that the current international crude oil price contains a geopolitical risk premium of $30/barrel
.

Phased price change refers to the change
in trading price caused by events that have a short-term impact on the trading expectations of the crude oil futures market.
For example, fluctuations in crude oil prices caused by changes in crude oil and distillate inventories regularly published by the International Energy Agency, the US Energy Information Administration, and the American Petroleum Institute; Saudi Arabia and other countries crude oil pipelines, production facilities, port facilities, etc.
were destroyed, and the Suez Canal was seriously blocked by accidents
, resulting in changes in trading prices.

Why oil prices fell this time

Before the fall in oil prices, the relationship between supply and demand in the international oil market had not fundamentally changed, and the international crude oil supply was in a continuous tight situation
.
However, at the level of economic operation, European and American countries and regions experienced the worst inflation in 40 years, OECD countries have successively turned to tightening monetary policy, and the Federal Reserve has adopted unconventional measures to raise interest rates by 75 basis points at one time, leading to fears
of a serious recession.
The reasons for this drop in oil prices can be summarized in three ways:

First, monetary policy continues to tighten and transaction costs rise
.
The futures market is an important part of
the financial market.
In the operation of the financial market, the cost of capital directly affects the transaction cost, which in turn has a significant impact
on the market trading volume.
Therefore, after the Fed raised interest rates three times in a row and announced its commitment to return inflation to its policy target of 2%, another 75 basis point rate hike in July is not ruled out, creating stronger tightening expectations
.
This led to a sharp decline in almost all financial markets, including crude oil futures, and the systemic risk of financial markets was released
.

Second, recession expectations have strengthened, and there is concern about a sharp decline
in crude oil demand.
To this day, the crude oil futures market is still remembering the cliff-like decline in demand that occurred in 2020
.
With high inflation, a tightening cycle of monetary policy taking shape, and sharp increases in international commodity prices, including crude oil, slowing economic growth is the consensus and expectations of a recession are strengthening
.
On the one hand, crude oil prices are running at a high level, and in the context of new energy development, oil consumption demand may be reduced due to the effect of energy substitution; On the other hand, if the recession accelerates, energy demand will fall rapidly, and with high crude oil prices, cutting energy costs will be the focus and demand will continue to decline
.

The third is to create trading opportunities
.
Under normal circumstances, financial markets need to be opened and traded
every day.
To make money in trading, it is necessary to have market fluctuations and trading spreads
.
In the case of various factors affecting the price is relatively stable, the market operation is also relatively stable, and the price fluctuates
in a narrow range.
However, there are often inflection points
in the operation of the market at this time.
Some traders suddenly amplify their expectations of a factor and its impact and trade accordingly, causing the market to be more volatile
.
Other traders do not know why the market is volatile and trade out of safe-haven needs, further exacerbating market volatility
.
Before the sharp drop in international oil prices, many factors in the market were in a stable period and were fully reflected in the trading price, so traders only looked for trading opportunities
through the changes in inventory data released weekly.
In such a market climate, the expectation of a future recession becomes an important factor
.
Injecting more pessimistic expectations into the crude oil futures market will create new trading opportunities, first stimulating the decline in oil prices on the grounds that demand may be greatly reduced, and then prompting traders to reassess the extent and impact of the recession and repair the market, which is conducive to forming trading spreads and creating opportunities for new trading
.

What factors affect the future market

After the fall in oil prices, from the K-line chart pattern, the trading price has fallen below the moving average system, only running above the annual line, international oil prices are considered to have entered a technical bear market, and the market may continue to run downward and challenge the annual support
.
But this is only a technical analysis of trading, and the real trend change must be judged
according to various influencing factors.
Currently, 3 factors
should be focused on.

The first is the degree of
economic recession in major economies.
In other words, the most important factors that contributed to this drop in oil prices need to be re-evaluated and confirmed
.
On the one hand, affected by the epidemic, the global economy is still recovering, but the global supply chain problem has not been resolved, resulting in a global shortage of goods, which has contributed to the rise in the price index; On the other hand, crude oil is not the only commodity whose prices have risen sharply, and the price of energy such as coal, natural gas, and electricity has risen even more, and the impact on the price index has also been greater
.
Therefore, the current inflation is not caused by an overheated economy, but by a shortage of supply caused by poor supply
chains, etc.
A strong tightening monetary policy to curb inflation does not solve the problem of global supply chains, and the rising cost of capital will depress economic growth
.
It remains to be seen how quickly the subsequent economy will enter a recession, to
what extent, and to what extent it will hit crude oil demand.
If there is indeed a severe recession as described in the Citibank study, a downturn in oil prices will be inevitable
.

The second is the degree of
reduction in international oil supply.
There is no doubt that there is a consensus that the current international oil and gas industry is underinvested, which means that it is difficult to achieve considerable oil production growth
in the short term.
If the economy does not enter a severe recession and significantly reduce oil demand, then the international oil market will be in a state of short supply, and it will be difficult for oil prices to fall
.
Affected by geopolitical factors, the supply in the international market may be further reduced, aggravating the situation of short supply and demand, triggering further increases
in oil prices.

The third is whether new "black swan" events
will occur.
At present, the international political and economic situation is turbulent, the game of big countries is intensifying, and the international crude oil market is facing huge uncertain risks
.
If unexpected political, economic or geopolitical events occur, it will seriously affect the efforts to rebalance the international oil market and trigger sharp changes
in international oil prices.

In short, from the perspective of international oil prices formed by futures market transactions and price composition analysis, the relationship between supply and demand has retreated to the bottom of the price logic, and financial factors and geopolitical risk factors have become new dominant, with a strong premium
.
The drop in oil prices stemmed not from supply and demand, but from expectations
that the economy would fall into a deep recession.
Under the current situation that the relationship between supply and demand is basically clear and monetary policy has entered a tightening cycle, the future market needs to focus on the severity of the recession from the demand side, the supply change in the international crude oil market from the supply side, and whether there will be new "black swan" events
in the increasingly complex international political and economic situation.