HDRO - USO: Tough Pills For The Oil Bulls To Swallow

Summary

• Oil prices have kickstarted 2023 with their worst decline since 1991.
• With at least one-third of the global economy set to be in a recession this year, including the US, demand will continue to be suppressed.
• This could mitigate the expected demand boost from China.
• It also comes as OPEC output is expected to recover as production from Nigeria and Venezuela comes online.

Oil ( USO ) is collapsing after a near-generational surge partially sparked by Russia's invasion of Ukraine. WTI crude futures closed at $73.8 per barrel last week Friday, still at its lowest level since 2021. Brent crude futures closed at $78.56, also at its lowest level in over 12 months. The outlook for oil in 2023 looks dire with bulls looking at the mythical Chinese reopening to offer a salvo. This has placed bullish 2023 oil forecasts into view from Goldman Sachs's $110 Brent crude price target to $140 from hedge fund manager Pierre Andurand.

With the largest land war in Europe since the end of the Second World War coming to its first full year, the waves of sanctions and the inherent disruption of Russia's weaponization of energy have been fully digested by the global energy market. We are now entering a period of normalization where economic forces will drive the next phase of oil price growth. Hence, there is some tough pill for oil bulls to swallow as energy companies that had their best earnings on record last year start to pull back to their pre-war trendlines.

The Global Economy Is Really In Dire Straits

Herein lies the core antithesis of the extremely bullish oil trade, expensive energy sparks supply-side inflationary pressure which forces up interest rates. These dual factors of rising interest rates and falling real incomes look set to lead to a full-blown global recession. The Fed is expected to implement another 75 basis points worth of hikes this year with rates expected to rise to between 5% to 5.25%, a nearly two-decade high.

The IMF is forecasting a recession to affect one-third of the global economy this year with a Bloomberg survey of economists in December placing the chance of the US falling into a recession at 70% , up from a 65% chance from the same survey conducted in November. A soft landing would of course be ideal for the broader stock market and to minimize economic suffering, but that looks to increasingly be a distant dream.

Whilst the broader US unemployment rate has remained stable since its pandemic spike, technology is already in a recession and I think this could be foreshadowing the direction of the US economy. Tech layoffs have surpassed their COVID-19 peak, with 17,130 layoffs announced in the first week of January alone. This is 23% of the total for the whole of the fourth quarter of 2022.

Broader unemployment is a lagging indicator and this will undeniably ramp up as most companies would have put off mass layoffs until after the Christmas break. The haunting specter of a recession grows larger each day and is set to be the dominant story for most of 2023.

The Chinese Reopening Demand Story

Whilst Russia's failed attempt to seize Kyiv, Odesa, and the Donbas was a core factor in the upward direction of oil prices last year, a broader supply and demand imbalance from COVID reopenings also came into play.

Expectations from some oil bulls are that demand for oil will grow by around 4 million barrels a day in 2023, around a 4% year-over-year increase. The International Energy Agency is expecting total oil demand growth of 1.7 million barrels a day in 2023. This would increase total 2023 demand to 101.6 million barrels a day, up from 99.9 million barrels a day in 2022. China's inherently triumphant rollback of its zero-covid policies is expected to underlie this growth, however, it has so far not been met with the cheer expected by oil bulls. Oil prices fell by 9% in the first two trading days of 2023, the worst start to a year since 1991.

With a lack of numbers on actual cases and deaths, it's hard to model when cases will peak. However, general forecasts are for cases for most Chinese cities to peak and then start falling from late January. Whilst temporary, soaring covid cases will continue to keep a lid on Chinese economic growth with its emerging industries purchasing managers index, a leading indicator for Chinese PMI, falling below 50 to 46.8 in December. This was the lowest reading since April 2021.

Further, expected Chinese jet demand for fuel might be partially mitigated by the broad reinstatement of travel restrictions being brought in globally as a direct response to soaring cases. The US and UK are both mandating pre-flight COVID-19 tests for travellers from China, Japan and Italy will require testing on arrival and Morocco has entirely banned all entry by Chinese travellers. Hence, international Chinese travel demand will likely continue to be somewhat fragmented until cases comprehensively move past their peak. This likely won't happen until spring.

OPEC Output Is Recovering

Overall, the unique concentration of geopolitical events that sparked a rally in oil last year has moderated. Whilst OPEC still has no spare capacity to boost supply, output for the cartel is edging higher due to a rebound in production from Nigeria.

Oil output from the West African oil giant is recovering, recently reaching an 8-month high of 1.35 million barrels a day. This entirely drove OPEC's output boost of 150,000 barrels a day in December. The cartel's production of 29.14 million barrels a day could move higher still on the back of further output gains from Nigeria as the country's production is still below its pre-pandemic average of just under 2 million barrels a day. Further, with the thawing of US relations with Venezuela, oil output from the South American country is set to also recover. This has placed Maduro's goal for PDVSA, Venezuela's state-owned oil company, to boost production to 1.5 million barrels a day back in view.

Fundamentally, the dynamics of the oil demand and supply paradigm look bearish for most of 2023. There will be some volatility of course, but the overall outlook is for demand to drop on economic woes that will entirely mitigate the much vaulted Chinese reopening demand whilst supply stays constant at a minimum. USO has further downside ahead.

The play here is to sell USO, an exchange traded security that tracks WTI, as crude oil moves to trade lower over the year. USO buys listed crude oil futures contracts and forms one of the most direct ways to gain direct exposure to the commodity.

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