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Market Insights

Oil to $200? Demand destruction, recession?

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There’s a definite feeling that “everything changed” in global energy markets after Russia’s invasion of Ukraine. No going back to the way things were. No way for Russia to return to the international fold.

At this point we should pause to add the obligatory disclaimers about truth often being stranger than fiction and predicting the future being notoriously difficult.

Who would have predicted the US banning imports of Russian oil so soon after leaving energy out of the original Russian sanctions?

For now, nobody truly knows what the implications are, nor the next decisions that governments and producers will make. But the uncertainty has driven spot oil prices higher.

Let’s start by taking a look at the charts. First off, a simple snapshot of the Brent oil futures curve at different time horizons:

Brent Oil Trading view futures curve at different time horizons

The curve is trading in serious backwardation right out until next year. (Backwardation is when the current price is higher than the price in the futures market). Essentially, demand for oil in the here and now is driving the price higher, but traders anticipate the price returning lower in the future.

In the chart, the yellow line is the front month (current) futures contract price, turquoise is the December 2022 price, orange is the June 2023 price and blue is the December 2023 price. The backwardation is clear from top to bottom.

So, where’s “$200 oil” coming from?

It could be any number to be honest. Stick your finger in the air and pick a high number seems to be the order of the day!

  • Russia’s energy minister warned on Monday that oil could rally to $300 per barrel if their energy exports are cut off from the world.
  • Goldman Sachs forecast the average 2022 price at $135 per barrel
  • JPMorgan predicted Brent could hit $185 by year-end
  • MUFG Analysts flagged the potential for prices to reach $180 per barrel (even though they stressed that this isn’t their base case scenario)

They point to history and two periods (1979-81 and 2004-08) that were also characterised by a supply-constrained oil market. In both cases, they say a severe spike in oil prices led to demand destruction which subsequently led to global recessions.

RBC makes a similar argument:

"it is not unfathomable for prices to rocket to $200/bbl by summer, spur a recession and end the year closer to $50/bbl ($200 call options have been bid)."

So, that’s probably the worst case scenario roughly defined. Regardless of the specific prices mentioned, if oil gets too expensive, demand destruction leads to a recession…

Demand destruction is a permanent downward shift on the demand curve in the direction of lower demand of a commodity, such as energy products, induced by a prolonged period of high prices or constrained supply.

Vitol’s Asia head Mike Muller says prices will find the “weaker demand” first:

“The world does not have enough spare capacity, the world doesn’t have enough crude either,”

“The law of high prices is going to have to weed out the weaker demand and destroy it.”

The demand destruction leading to recession scenario played out in 2008 when Brent oil almost hit $148 per barrel. We’re not far away from that now…

Oil Brent one week movement trading view

Where is this “weaker” demand?

The EIA has some important data to consider on this point:

The Organization of Economic Cooperation and Development (OECD) consists of the United States, much of Europe, and other advanced countries. At 53 percent of world oil consumption in 2010, these large economies consume more oil than the non-OECD countries, but have much lower oil consumption growth.

Oil consumption in the OECD countries actually declined in the decade between 2000 and 2010, whereas non-OECD consumption rose 40 percent during the same period.

China, India, and Saudi Arabia had the largest growth in oil consumption among the countries in the non-OECD during this period.

Two of these countries are not like the other. The main driver of Saudi Arabia’s economic growth has been (and still is) oil exports, whereas China & India rely enormously on energy imports.

Fuel prices in India have remained unchanged despite the increase in global oil prices. Assembly elections are taking place in five states, with the results due to be declared on March 10th. There’s plenty of speculation in India that fuel prices will rise soon after.

Hardeep Singh Puri, Union Minister for Petroleum and Natural Gas tried to reassure the public:

"I assure you all that there will be no shortage of crude oil. We will make sure that our energy requirements are met, even though 85 per cent of our requirements are dependent on imports for crude oil and 50-55 per cent on gas."

With such a reliance on crude oil imports, India may be one of the hardest hit countries.

How about OPEC+?

Well, this is where there may be some hope for short-term relief. OPEC Secretary General Barkindo was pressed for answers as to why OPEC+ are still restricting supply in the face of such high prices.

His response?

"Let's see what happens at the next meeting."

Even still, the International Energy Agency says that most OPEC+ members have little spare oil production capacity now. Saudi Arabia & the UAE are the main exceptions.

Barkindo also cautioned that Russia’s supply would not easily be replaced:

"There is no capacity in the world that could replace 7 millions barrels per day."

Goldman Sachs analysts have already built the OPEC relief into their assumptions and see oil prices ranging between $115-$175/bbl in 2022 "even assuming SPR and OPEC supply relief."

They also say long-dated oil prices remain "significantly underpriced", suggesting that high prices will stick around for longer than the futures curve is currently pricing. The polar opposite to RBC’s suggestion of $50 per barrel by year end due to recession.

When it comes to the oil market, the only thing that seems certain right now is uncertainty.

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

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