Oil retreats as peace hopes rise, but depleted inventories may limit the downside

The case for lower prices in the short term is compelling. Millions of barrels currently stranded in the Gulf are being prepared for export, while the market has already demonstrated a surprising ability to adapt. A surge in U.S. exports, weaker Chinese imports, alternative pipeline routes from Saudi Arabia and the UAE, and some demand destruction helped offset a significant portion of the disruption, preventing an even larger price spike.

While exports may return to pre-war levels during August, markets may underestimate the challenge of restoring production and rebuilding inventories. Exports can recover relatively quickly once shipping resumes, but production takes longer. With thousands of wells shut during the conflict, some may not immediately return to previous output levels. Goldman Sachs expects Gulf production to normalize around October, while Morgan Stanley sees only half of disrupted production returning by September and around 80% by year-end.

This distinction matters because the global oil market has accumulated a substantial supply deficit during the conflict. Inventories were already relatively low before the war and have since been drawn down aggressively. In the United States alone, combined commercial and Strategic Petroleum Reserve holdings have fallen by more than 80 million barrels, with the SPR down to a 1983 low.

Several factors support the view that oil may establish a new floor above the USD 60-70 range. First, inventories need to be rebuilt, both commercially and strategically. Governments in the United States and Asia have become increasingly aware of supply vulnerabilities and are likely to replenish reserves once conditions allow.

Second, demand may recover as prices retreat. The third quarter is seasonally the strongest period for oil consumption, and lower fuel costs tend to stimulate demand. In addition, weak Chinese imports—one of the key balancing factors during the crisis—may prove temporary. A return to more normal Chinese buying patterns would absorb part of the additional supply expected to reach the market.

Third, the geopolitical risk premium is unlikely to disappear completely. While the current agreement may reopen the Strait of Hormuz, many underlying tensions remain unresolved. Regional security concerns persist, and shipping companies may remain cautious for some time. Even under an optimistic scenario, traders are unlikely to assign a zero probability to future disruptions.

In that sense, the market has effectively borrowed barrels from the future. Inventories were drawn down, floating storage reduced, alternative supply routes maximized and demand suppressed in some regions. Those adjustments helped contain the shock but now need to be reversed. Restoring inventories to more comfortable levels may take considerably longer than reopening tanker traffic through Hormuz.

The 2027 average price for Brent and WTI are currently trading at USD 75 and USD 71 respectively, both more than 10 dollars above their pre-war level, highlighting market expectations that prices will remain higher for longer.

Months of strong backwardation lifting investor return

While the focus today is on peace and falling prices, investors should not overlook what has been an exceptional period for energy returns. The gains generated during the conflict extended far beyond the increase in outright prices thanks to extreme backwardation across the futures curve.

The impact was particularly evident in refined products. London gas oil delivered a total return approaching 50% even though the nearby futures contract gained only around 22%. Brent crude generated a total return of 32.5% while the front-month contract rose just 13.2%. WTI crude returned nearly 38% compared with a 20% gain in the underlying contract, while NY ULSD diesel produced a total return above 42% against a 21% rise in nearby futures.

These returns underline the powerful contribution that roll yield can make during periods of acute supply stress. For investors with long-only exposure, backwardation proved almost as important as the move in spot prices. From a sector perspective, the Bloomberg Energy Total Return Index, which includes natural gas has returned 28% during the conflict, almost double the return shown on spot index which tracks the performance of the underlying futures.

Looking ahead, the balance of risks appears more evenly distributed than at any point since the conflict began. Near-term downside risks remain as the market prices a faster reopening of the Strait and a return of stranded barrels. However, depleted inventories, seasonal demand strength, strategic stock rebuilding and lingering geopolitical uncertainty suggest that the path back to pre-war oil prices may be far less straightforward than current market optimism implies.

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