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Market Insights

Oil - G7 Price cap vs China's lockdowns

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Choppy price action for oil looks to be resolving into weakness, which is largely being attributed to China’s continuing battle with Covid and the resulting persistent lockdowns. Further downside ahead, or will OPEC+ step in?

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A clear trading range has been established now. Resistance is at the upper end of the range in the $100 zone, with the 200 day moving average just beyond. Support and the lower end of the range is just above $80.

The oil price, like most commodities, is usually driven by supply and demand trends. A price cap on Russian oil, such as the one G7 countries are currently pushing for, introduces another factor to consider. Earlier this year, G7 countries had proposed a cap in the $40-$60 per barrel range.

The price range under discussion has subsequently been increased to $65-70 per barrel.

__Why the higher price? __

Goldman Sachs analysts call this a ‘classic Stackleberg game’: the G7 leads the way but also needs to anticipate Russia’s response to the price caps:

The G7’s updated proposals seem more appropriate, minimising Russian revenues whilst also limiting retaliation risk. To that end, today’s price action reflects a downward reassessment of the latter risk. However, the announcement increases the risk of retaliation from other global exporters, for whom the price cap may set a concerning precedent.

Adrian Biernacki, a spokesman for the Polish representative to the EU didn’t get the memo: "In principle, Poland supports the price cap on the Russian oil but the proposed level is extremely too high,"

The largest retaliation risk is that Russia follows a similar strategy as they did earlier in the year with gas flows into Europe. In theory, if they produce less oil, this would cause prices to spike due to disrupted supply. Russia receives similar revenues for less oil production due to the higher prices. The G7 are ‘punished’ by higher oil prices, and the sanctions are ineffective. The price cap is also an unwelcome development for OPEC+, as it sets an unnerving precedent for the future.

A final decision is yet to be reached.

Early next week, the US treasury is reportedly set to grant Chevron permission to revive oil output and trading privileges in Venezuela, which could boost the overall supply picture for the future. Venezuela’s output has been dwindling after years of sanctions amid illegitimate elections and allegations of corruption.

However, China’s battle with Covid still looks to be a massive factor in global demand. The reopening was supposed to be accelerating by now. Instead, Beijing’s business district has turned into a walker’s paradise. Barely any traffic. An eerie calm in the city is reminiscent of the early days of global pandemic lockdowns.

A Foxconn factory responsible for iPhone production has seen worker protests due to pay disputes, Covid cases and conditions at the plant too. The social fabric is at risk of unravelling.

If Chinese demand isn’t revived and the global economy continues to slow, it’s hard to imagine oil prices breaking out of the current trading range to the upside. However, it’s also hard to imagine OPEC+ keeping production constant if the demand picture weakens and prices slide. Supply cuts could be announced to keep prices roughly stable in the current range.

Not investment advice. Past performance does not guarantee or predict future performance.

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