The great oil head fake

It’s incredible to think that since Russia invaded Ukraine, oil prices have actually dropped from roughly $100 a barrel to around $60 today. There are good reasons for this — too much supply, lower demand in some big consuming countries and even the sense that we overestimate the effect of geopolitics on the market.

In my view, though, they are being underplayed. Huge protests in Iran and threats of a US military strike raised prices by only a few dollars. The threat of a potential trade war with Europe over Greenland then flattened them again. But markets are terrible at pricing political risk, which is by nature illiquid (each political event is, after all, a kind of one-off) and tough to model. Meanwhile, there are other reasons to think that we may be about to see oil prices start to head higher.

Let’s start with Chinese stockpiling. As Gavekal Research pointed out in a client webinar last week, despite the move to electric vehicles and the slowdown in the Chinese construction sector, the country is still buying record volumes of crude. China is clearly building up a strategic petroleum reserve, which is a good idea given the fact that America is becoming a petrostate with a goal, clearly laid out in the Trump administration’s national security strategy, of ringfencing more natural resources.

On that note, one might argue that US control of Venezuelan oil will bring even more supply into the market, implying lower prices (although it’s worth noting that the market’s initial reaction was a 1.8 per cent rise in the price of crude because of uncertainty being introduced).

But even if you are bullish on Venezuelan resources, it will take at least 10 years and tens of billions of dollars to bring that oil to market. And so far, despite US President Donald Trump’s demands, the energy majors don’t seem eager to rush back into the country too quickly. Who could be, when there is little sense of what the political model there, and indeed in the US itself, will be over the next decade?

What is clear is that we’ve already hit peak oil production in the near term. Last September, the International Energy Agency reported that in 2024, around 80 per cent of global oil production and 90 per cent of natural gas production came from fields that had passed their production peaks. The report indicated that, barring any major new investment, production from existing fields would peak this year and decline rapidly — even with the use of water pressure injections and other techniques to squeeze out more production.

At the same time, the IEA can now see a scenario in which oil demand continues to grow, because so many countries are backpedalling on their clean energy commitments (led, of course, by the US).

A potential longer-term supply and demand mismatch implies higher prices. Despite this, the net long position in oil held by hedge funds is exceptionally bearish compared with the last several years, and the strong consensus view in the market for the coming year is still quite bearish. We may be living in a “just in case” world but most traders still have a “just in time” view on oil, and they seem to assume there is no trouble on the horizon.

And yet, in a world of increased political volatility, excess supply could disappear quickly for any number of reasons, from supply disruption in Iran, more turmoil in Latin America, a blockade of transport chokepoints in the Gulf or South China Seas, a natural disaster, or simply faster Chinese stockpiling.

The market discounting of such events coupled with unequivocal bullishness on equities “increases the odds that the opposite will happen — equities will fall and oil will rise in 2026”, as Currency Research Associates put it in a January 6 note to investors. Indeed, their analysis predicts $500 a barrel oil by 2030 (though it must be said nobody has successfully predicted the price of oil that far out).

This is in part because energy markets adapt and evolve when prices get too high. Whenever one energy source becomes too expensive, another rises to replace it. What’s more, history shows that when the world is going through the transition from one kind of fuel to another, there are often price spikes and lots of volatility. This is because supply chains and infrastructure in the new fuel are being built (requiring more energy), even as production in the old fuel is declining. This was true in the transition from, say, whale oil and woodfuel to coal, coal to oil, oil to gas and so on.

That leads to a final factor for investors to consider regarding the price of oil over the next few years. China may be stockpiling crude for geopolitical reasons. But it is also eager to move more quickly to a clean energy future, leveraging its competitiveness in green technologies such as lithium batteries, electric vehicles, solar panels and the like. This is a way not only to bolster its own economy and ambitions to lead the world in the clean energy sector, but also to decrease reliance on fossil fuels at a time when the US is trying to control more of them.

Just as dollar-based sanctions pushed countries at risk of US financial retribution to hold a more diverse basket of reserves, perhaps petro-politics and higher oil prices will spark a faster green transition. That would be a rare silver lining for the energy story in today’s chaotic world.

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