Oil Drop Raises Glut Fears Amid Flow of Hormuz Supplies and Weak Chinese Demand

SadaNews - Oil prices are declining everywhere as the peace agreement between the United States and Iran unleashes a wave of supplies that exceed buyers' demand and fuels talk of a surplus.

This is a remarkable shift; less than three months ago, the main benchmark for global oil (Brent crude) hit its all-time high, and just a few weeks earlier, top executives in the sector warned that global inventories were nearing critically low levels.

Today, the future of the Iran war remains uncertain, and a significant portion of Middle Eastern production is still halted. Global inventories have already sharply declined during the war. However, Brent crude has surrendered all of its gains made during the conflict, trading near $70 per barrel, while the actual oil market is sending signals of weakness more severe than any time since the demand collapse during the COVID pandemic.

Concerns of Oil Supply Glut

For the global economy, this dramatic shift from scarcity to abundance has all but eliminated concerns about a potential inflation spike driven by Oil due to the largest recorded disruption in supplies. For major oil producers in the Organization of the Petroleum Exporting Countries, this means that questions about how quickly they can restore output may soon be replaced by queries about whether they are prepared to curb supplies to support prices, or if they will find themselves ultimately in a market share race.

Beyond the immediate impact of the reopening, analysts from Morgan Stanley and Goldman Sachs warned this week that the market faces the danger of a glut as next year approaches.

Kate Hains, head of oil at the consultancy Energy Aspects, stated: "The prevailing sentiment now is bearish."

Even before the U.S. and Iran signed a memorandum of understanding to reopen the Strait of Hormuz in mid-June, suppliers within the Arabian Gulf were increasing shipments. But in the following weeks, more than 60 million barrels of oil that had been trapped at their locations when the war started began to flow.

Saudi and UAE oil exports are at levels they were shipping prior to the Iran war, or close to them, supported by U.S. military protection while navigating the Strait of Hormuz, along with pipelines they used to bypass the waterway. Iranian oil, which had been subjected to stringent U.S. sanctions for years, has again become available for purchase after the U.S. issued sanctions waivers.

War-time Alternatives

The recovery of navigation in Hormuz coincides with the continued availability of many oil market alternatives during the war. China, which had helped stabilize the global market by sharply reducing its purchases, has not yet returned to the market with significant force. Each week, millions of barrels continue to flow from emergency underground storage caves on the U.S. Gulf Coast, within record draws of 400 million barrels intended to mitigate a nonexistent oil crisis.

Natasha Kaniva, head of commodity research at JP Morgan Chase & Co., wrote in a note: "The market faces a risk of a temporary glut as the stranded oil finally returns to a system that has been learning to behave in its absence for months." She added: "The cargoes now exiting Hormuz are increasingly finding that the only place to go is China. But Beijing is not buying."

Tankers Roaming Oceans in Search of Buyers

This surplus is reflected on trading screens on Wall Street, as well as on the giant tankers traversing the world's oceans.

In recent days, both U.S. and European and Asian futures benchmark indices have traded in contango. This structure incentivizes traders to store barrels of oil when supply exceeds demand.

Emirati oil is being shipped to far-off areas like the U.S., and is even being offered to buyers in Hawaii. A ship loaded with Venezuelan crude has traveled more than 10,000 miles to the Indian coast and has been anchored for more than two weeks without a buyer.

One of the main reasons for these unusual trips is that China, which has reduced imports by about 5 million barrels per day from pre-war levels, has not yet materially increased its purchases.

Weak Chinese Oil Purchases

In a sign of how weak Chinese buying is, the prices of the oil grades that the Chinese usually purchase have fallen to historic lows. The spot price of Oman crude, a key grade of Middle Eastern oil, has traded at a discount of $4 to the Dubai benchmark, the largest discount since 2020. A shipment of Djeno crude from the Republic of the Congo has not sold despite being offered at a discount of $14 to Brent, the widest discount ever. While some indicators last week suggested Chinese refineries were opportunistically buying shipments of Middle Eastern crude, analysts say those purchases are not yet large enough to change sentiment.

Analysts at Citigroup, including Francesco Martuchia, wrote in a note: "Chinese buyers remain conspicuously absent." They added: "Without a tangible return of Chinese demand, the additional barrels pushed into the market do nothing but deepen the emerging surplus."

One-Time Boost

Nonetheless, there are reasons to believe that the actual oil market may not remain this weak for long. The initial rush of oil stranded in Hormuz represents, by definition, a sudden non-recurring boost to supplies. Production in the Gulf is rapidly increasing, but it still lags somewhat behind pre-war levels, as a Bloomberg survey showed that OPEC's output in June was 28% lower than in February.

Oil product markets seem stronger than crude. European futures contracts for diesel are priced about $50 per barrel higher than crude, as traders are worried about a sharp drop in Russian shipments last month, and the potential for an export ban. The gasoline market is also under pressure, as inventories in the U.S. are far below seasonal norms, partly due to refineries focusing on jet fuel production in recent months.

Strategic petroleum reserve withdrawals are expected to slow down before stopping completely next month, according to the International Energy Agency. Some analysts expect governments to quickly seek to rebuild their inventories, adding to demand and helping absorb any surplus.

What Awaits the Oil Market?

The coming period is likely to depend on three factors: whether the fragile peace agreement can hold, whether the OPEC+ producer coalition is willing to restrain the recovery of its output to protect prices, and China.

Jorge Leon, head of geopolitical analysis at Rystad Energy, who previously worked at the OPEC secretariat, stated that the return of flows through Hormuz to normal will pose difficult questions for the coalition.

He explained: "The real challenge will begin once flows return to normal, rebuilding inventories, and the coalition will have to shift from reintroducing halted supplies to defending the market." He added: "Then the question becomes not how much OPEC+ can produce, but who is willing to cut."

Iraq expresses confidence in raising its production quota as OPEC+ meeting approaches.

As for China, some see the possibility of sharply declining prices, with Middle Eastern producers beginning a new monthly sales cycle in the coming days, may lure Chinese refineries back to the market.

Hamayon Falakhshahi, senior analyst at the information company Kpler, stated: "Iranian oil is struggling to sell, despite the waiver. In China, crude from the UAE and Iraq has become cheaper even than Iranian oil." He added: "For a recovery to happen, we need China's return, but I think we are close to the bottom."