From Global Risk Management
The Oil Market Annual Outlook Jan'2021
From Global Risk Management
The outlook in less than 60 seconds....
Oil market participants are finding their feet after a year of turmoil where the Covid-19 pandemic turned the world upside down.
In the following, we look at how different parts of the world were affected by the pandemic and what the outlook for oil prices is for this year. We also describe the demand/supply drivers and the current geopolitical environment.
In the last part of the outlook, the special feature articles, we give our input to the shipping industry’s challenge with cleaner and greener fuels as well as suggest what companies could do when markets are disrupted by extreme events, like the one we saw in 2020.
2020 initially set out to be a good year for oil sellers, with rising demand and continued economic activity. It didn’t take long, however, before the worldwide pandemic put an end to the optimism. As we have now left 2020, we intend to provide a fundamental understanding of the drivers for supply and demand in this tumultuous year and where 2021 will take us.
Demand for oil has slowly regained its position but remains well below pre-pandemic levels. The outbreak of the pandemic lead to a sharp decrease in oil demand as worldwide lockdown measures were implemented. The sharp decline was however, quickly followed by v-shaped recovery, which is often looked upon as best-case-scenario given a recession. The recovery can in large part be attributed to demand from China, which we will analyse further in the next section as well as demand from India. The U.S. and OECD countries are another story, however as re-imposed lockdown measures appear to have taken their toll and especially in Europe, where 4Q20 oil demand was weaker than the 3Q20 demand was.
World oil demand is anticipated to decline by between 8.8-9.8 mb/d in 2020. As uncertainty continues to rule the landscape going into 2021, forecasts on demand in 2021 should be viewed accordingly. Reports suggest an increase in demand in 2021 of between 5.70-5.90 mb/d, which is a reduction of approximately 3 mb/d compared to 2019 levels. A large part of the contraction is attributable to a decline in transportation fuels, which we probably will see reach 2019 levels in 2021, but more importantly a huge loss in demand for jet fuel that reports suggest are accountable for 80% of the 3 mb/d loss in 2021 vis-à-vis 2020.
A quick dive into the demand situation in China is valuable as it helps understand differences between demand for oil in the OECD and China, and why exactly some countries still manage to display healthy economic activity. The Chinese crude import graph suggests that production in China was kept relatively high and where demand due to ongoing economic activity was indeed needed. A large part of the oil demand by China is from the use of LPG, which is a liquid gas mainly used in the commercial sector (manufacturing), but also in households. Moreover, China has been taking advantage of the low crude oil prices to stock up the reserves. The demand for oil in China in 2020 was 91.3 mb/d compared to 100.1 mb/d in 2019, a rather small decline.
In short, what has been driving the demand for China was likely a still thriving commercial sector and a large household consumption of LPG, whereas the demand for oil by the OECD and the U.S. is largely made up of transportation fuels and Jet fuels, which for obvious reasons has been lacking severely.
Even though the current data suggests a sluggish end to 2020, the optimism on future demand holds firm. The biggest drivers of rallying prices are undoubtedly vaccines and the U.S. aid-bill while uncertainty on Covid-19 mutations is applying downward pressure. For example, as Pfizer first announced that its vaccine proved 90% effective, the crude oil price rallied over 12%. Although, it will take a while for the vaccine to actually impact the macroeconomic situation, as it will take several months before we reach a critical mass of vaccinated people. Combined with the fear of a mutated vaccine in the UK and other countries, which put downward pressure on prices, optimism will be accompanied by uncertainty for quite a while. Fiscal stimulus will also play a role in future price developments. In end-December oil prices reacted positively to news that Trump signed the new relief package in combination with news that democrats will try to expand the relief payments to 2000 USD to each U.S. citizen. It will be interesting to see whether Joe Biden will follow up with another aid bill when his presidency starts later in January.
On the supply side of the equation, we have seen worldwide oil production put on hold trying to prevent a glut. Moreover, on the back of the deepest-ever production cuts back in April, OPEC has been trying to act proactively on the supply side. Hence, OPEC+ reached an agreement in start December, which involved scaling back production into 2021 to only supplying additional 500,000 bpd in 1Q, versus the planned 2 mio. bpd. The parties will meet regularly to readjust, with OPEC+ controlling just about 50% of global production any change in production will of course have impact. This down-scaling came amidst renowned optimism due to vaccine developments, but suggests, as touched upon earlier, that it will take a while for vaccines to actually impact demand figures. In the following section we will dive deeper into world production graphs, supply drivers of oil prices as well as an overview of the current shale oil production status in the U.S.
Non-OPEC supply was down by 2.50 mio. bpd in 2020, putting the liquid output for 4Q20 to 64 mio bpd. Russia, U.S., UK and Canada are among the producers showing the largest decline in production in 2020. Going into 2021, the non-OPEC production is forecasted to grow by 0.85 mio. bpd. The main drivers behind the growth in 2021 are expected to be U.S., Canada, Brazil, Norway, Qatar and Ecuador. OPEC crude production is estimated to average around 27.5 mio. bpd in 2021 versus 25.6 mio. bpd in 2020.
As a sign for the improving economy is the current production status, which follows demand closely. Taking a look at the U.S. crude production, we see that it peaked in March, but quickly plummeted afterwards to lowest levels just under 10 mio. bpd in September. Production still is far off pre-pandemic levels, but higher supply can now be seen as per the graph.
Another indicator of a positive outlook is the increase in rigs in the U.S. Since April 2020, rigs have been sharply declining in the U.S., but recent numbers seem to indicate that the tide has turned. The U.S. has added just shy of 100 rigs since mid-August. More rigs usually means higher output albeit with delayed timing.
OPEC production followed the trend of the U.S. however, the group of oil producers found it necessary to decrease supply sharply in April. It has since recovered and is forecasted for more recovery during 2020.
The trend is further established in non-OPEC crude production. For the total production including OPEC, non-OPEC and the U.S., the trend is established as being the same as these provide a large part of their production to Western countries, whose demand is highly dependent on transportation fuel and jet fuel.
Jumping on to one of the most impacted refined oil products, we turn our attention to the Kerosene, which essentially is jet fuel. The outlook for Kerosene in 2021 remains weak. Although a small pickup in supply is viewable in the graph, the overall demand for jet fuel will remain low. As mentioned earlier, the lack of demand for jet fuel accounts for approximately 80% of the downfall in demand in the OECD. Kerosene saw a drop in production from around 2000 kbpd in end 2019-start 2020, to a decline to near 400kpdb. This sharp reduction is an effect of the large decrease in flights. On the 9th of August 2020, the number of flights was half of that they were last year at the same date. S&P estimated a reduction of 35% in U.S. jet fuel consumption this year. What’s more, refinery margins have been hit severely by the decrease in demand, which in turn has meant that many refineries have shut down or repurposed their refinery to other closely related products such as diesel.
OPEC and OPEC+ have always been a cause for concern when disputes between countries have been apparent. Saudi Arabia wanted to make a case for extending the production cuts of 7.7 mb/d into 1Q21 due to worsening demand numbers, but other OPEC countries found it unnecessary to carry out extended cuts as oil prices rallied. In the end a compromise was reached to move away from the previously agreed production increase from start 2021 of 2 mb/d to only increase it with 500.000 bpd.
Discussions will be ongoing into 2021 as some might argue that a mix of increased production by OPEC+ and worsening Covid-numbers might see prices spiral downwards again. The story is also a new turn on the “2020 to cut or not-to-cut” production-battle between Russia and Saudi Arabia, which was also the main driver behind the huge decrease in oil prices witnessed at the start of the pandemic.
The U.S. shale industry has been under pressure for a number of years. Investors have been fleeing the industry due to heavy environmental regulations and large start-up costs connected to initiate drilling. The pandemic has certainly caused more issues. U.S. shale rigs dropped from 681 in March to only 69 shale rigs in the summer. This number has since been increased to 241 in late November but is still far from pre-pandemic levels. The sharp decrease in U.S. crude output has had devastating impact on exploration and production companies this year, 43 of which have gone bankrupt. With prices rallying to over $50bbl, it is however, not necessarily the complete end for shale, as higher prices incentivise investors back into the fast cash-burning business, but it seems more and more unlikely that shale will help U.S. regain their position as the largest crude producer in the world.
Optimism seems to rule the markets as vaccines and economic stimulus are being rolled out, but simultaneously a fear of not being able to contain the virus effectively persists. We are still far from pre-pandemic macro-economic numbers and oil demand and 2021 will be a battle to get to pre-pandemic conditions. As effects of the vaccines won’t come around until later in 2021 and uncertainty still rules, we set the market to be slightly bullish going into 1Q21, as markets are often ahead of the underlying fundamentals.
The Financials section of our report will investigate and assess macroeconomic conditions as world governments try to fight an unprecedented economic downturn. Furthermore, we will look at key economic data points on the world's largest economies, the U.S., the European Union and China.
In a year that will be remembered for the Covid-19 pandemic, we saw the GDP drop significantly in the beginning of the year as the economy was shut down to slow the spread of Covid-19 and then rebound later as restrictions eased.
During the last quarter we have seen a rapid return to growth, however, we remain in negative territory for the year. If we were to draw parallels to the recession of 2007-09 where GDP also took a significant hit, it would take about a year to reverse the past years GDP growth rate.
The U.S. PMI fell to 57.5 in November after having reached a two year high of 59.3 in October. Even though this is a drop from the previous month it is still well above 50 thereby pointing to an expansion in the economy, this will then be the seventh month in a row where we have seen figures indicating expansion.
Production numbers have seen a slowdown the last month as well as new orders and inventories. However, new export numbers have increased more rapidly.
Overall, we continue to see the manufacturing economy continue its recovery as production continues to take place in redesigned factories. However, absenteeism, short-term shutdowns to keep up with sanitation regulations as well as difficulties in returning and hiring workers, are causing a strain that could very well limit future manufacturing growth.
Fed, the U.S. central bank, kept interest rates at the same low level in Q4. This was done to stimulate the economy and to help businesses get back to normal, this was also stated in a comment from the federal reserve which says it will keep interest rates low for as long as it takes the US economy to recover from the Covid-19 pandemic. The Federal funds rate is the rate that banks charge other banks for short-term borrowing and is not the rate consumers see, however there is strong correlation between the two.
The monetary stimulus packages which have been issued by several central banks around the world will play a pivotal role in regenerating the economy. The lowering of the interest rate which we saw in the end of Q1 has continued since, and recent comments from the Fed indicate that it will not be changed soon.
Despite some grim statistics previously in the year, in Q4 we have seen significant improvement in the number of people employed in the US. This comes as the country is slowly reopening again after most activity was shut down earlier in the year. However, even though the recent developments have been very positive the pace of which people are hired back is slowing and workers are starting to move into long-term unemployment, which categorised as someone who has been unemployed for more than 27 weeks.
The unemployment rate of October was 6.9% while it only dropped to 6.7% for November. This drop is therefore considerably slower than the drop seen from September to October where it dropped by 1 percentage point. A recent estimation from the Fed says that the economy is expected to return to a healthier during 2021. So far the sectors which have seen the biggest improvements are transportation, warehousing, professional and business services, and health care.
Much like the U.S., Europe has seen significant improvement in economic activity during the previous quarter. Some of the sharpest increases compared to the previous quarter can be found in France (+18.7%), Spain (+16.7%) and Italy (+15.9%). It should be noted that these economies were also among the countries reporting the sharpest decrease during the second quarter of the year. However, despite showing much improvement during the last couple of months we are still considerably below the levels seen prior to the pandemic. If we compare the third quarter with the same period in 2019, seasonally adjusted GDP had decreased by -4.3% in the Euro area and -4.2% in the EU this represents a partial recovery after figures of -14.7% and 13.9% in the previous quarter. Compared with the U.S. which has increased by 7.4% in the previous quarter, it can be argued that Europe is faring much better. This could in part be due to the more extensive furlough programs.
The Euro area manufacturing PMI increased to 55.5 in December from 53.8 in November. This reading pointed to the strongest growth in factory activity for the past 31 months. Output and new orders growth accelerated, and export of goods rose at the second fastest rate for 34 months. However, the positive increase in production has more than balanced out the drop in the service sector.
Activity in the Eurozone area has somewhat stabilised in December. Stronger production output growth has been led by Germany, this was accompanied by a decline in the service sector, which has contracted for a fourth successive month. However, it should be mentioned that the decline is the slowest since September as fewer companies have reported output to have been hit by lockdown restrictions.
As pointed out in our previous report, Europe has not had the same possibilities as the U.S. regarding monetary stimulus as interest rates were already below zero before the pandemic. This means that most European countries have relied heavily on fiscal stimulus as well as emergency packages to stimulate the economy.
In addition, the European Central Bank (ECB) has expanded its Pandemic Emergency Purchase Program (PEPP) by another €500 billion to at least the end of March 2022. This is aimed at supporting the Eurozone’s struggling economy caused by the pandemic. Also, policy makers have approved additional long-term loans at favorable terms for another year thereby extending until June 2022.
In December the euro area seasonally adjusted unemployment rate was 8.4%, down slightly from 8.5% in September. But higher than when compared to 7.4% from October 2019.
China has weathered the worst of the downturn caused by the pandemic and apparently rebounded well. This development has continued during fall as the Chinese economy has advanced by 4.9% during Q3 2020 - faster than the 3.2% expansion in Q2. Recently, signs of the improvement in GDP are starting to extend to consumption after the state backed industrial recovery. This can be seen by the fact that retail sales rose by 3.3% yoy in September. Industrial production went up by 6.9%, this is higher than expected and the biggest gain in 2020. In addition to a recovery in Chinese consumption there is still a great deal of uncertainty regarding how other countries are controlling the virus so the country can continue trade with others and thereby continue its economic growth. Also following the pandemic, we have seen the tertiary sector of the economy recovering slower than the primary and secondary sector. The tertiary sector has been the fastest growing sector for the past 5 years but has only grown by 0.4% whereas the primary and secondary sector have grown by 2.3% and 0.9% respectively.
Rising demand for medical equipment and work from home technology has increased exports as well as banks’ reserve requirements being lowered has helped to boost the recovery. This means that the Chinese central bank has cut the amount of cash that banks must hold in reserves, thereby releasing more liquidity into the economy. With these cuts banks only have a requirement to have a reserve requirement ratio (RRR) of 6%.
With the recent positive development in China the economy is now expected to expand by 2.1% in 2020.
Earlier in the year we saw a sharp V-shaped recovery in the Chinese Caixin PMI Index, and during the last months we have started to see a level that is higher than before the pandemic. However, the official NBS Manufacturing PMI has edged down to 51.9 in December from a 38-month high of 52.1 reported in November.
China was not affected as much as either the U.S. or Europe on the unemployment rate. This reflects the signs that we have seen in both the GDP and PMI for China. This can be somewhat attributed to large stimulus initiatives as well as increased demand for Chinese produced goods as much of the world was adjusting to working from home.
Financial data shows mixed global economic signals. However, much remains uncertain as the world continues its road to recovery from the pandemic. Based on the above analysis we can say that the Chinese economy is performing considerably better than both the U.S. and Europe. In these regions we can find comfort in the fact the governments continue to focus on stimulus programs. Looking forward all economic recovery depends on the successful roll out of the vaccine programs in all regions.
Hopes regarding the rollout of the vaccine is also that is receiving a lot of attention in the oil and energy markets as people are speculating when demand will return into the market. We have already started to see stronger Asian demand causing prices to go smoothly from contango to backwardation this is combined with effective OPEC+ management of the supply side.
The U.S. has a new president, Joe Biden. With the new president we might also expect some new policies that will influence the world’s energy markets.
Currently the U.S. is applying sanctions against Iran and Venezuela. These unilateral sanctions were imposed by the Trump administration. Biden, on the other hand, has shown an interest in more multilateral diplomacy, which could eventually lead to the sanctions against the two OPEC member countries being lifted. This, in turn, in Iran's case alone, would add approximately 3 percent to the world's crude oil production. Easing of the sanctions against Iran is probably not going to be at the top of Biden's to-do list, however. This is because of more urgent issues like the global pandemic, but also, the Biden administration is likely to wait until the Iranian presidential election (in June 2021) is over.
With Biden entering the White House, Americans and the world can expect decisions to be made for a greener future. Biden has made fighting climate change a priority and an important part of that is re-entering the Paris Climate Agreement. Biden has also made it his goal to ensure the U.S. brings down its emissions to net-zero by 2050.
The Trump administration pushed through some notable reforms to weaken emissions targets. Examples of these are the Affordable Clean Energy Plan (which replaced Obama's Clean Power Plan) and the U.S. Environmental Protection Agency's softening of vehicle emissions standards. The Biden administration is most likely looking to roll back these reforms to Obama era policies, which would lead to stricter emissions targets compared to the current situation.
Biden has vowed to ban the issuance of new drilling permits on federal lands and waters. In 2019, the amount of crude oil produced from federal lands and waters by the U.S. was nearly 3 million barrels per day. The number for natural gas was 13.2 billion cubic feet per day. With a ban on new drilling permits, these numbers could approach zero over a matter of years due to existing shale well depletions and conventional uneconomic wells.
Lastly, the focal point of geopolitics in our previous quarterly market outlook was the trade war between U.S. and China. Even though the relationship between the two countries remains tense, it is not as big a concern for the energy markets at the moment. Of course, the situation may develop after the new U.S. president takes office in January.
At the start of the year, Libya's oil output dropped from around 1.2 mbpd to 130,000 barrels per day because of a blockade imposed on five of its key oil ports. During the year, output of the North African OPEC member has remained low. For example, in May Libya only produced 80,000 barrels per day. In September, the blockade on oil production and exports was lifted. After that, Libyan oil production started to increase and in two months it was back to the pre-blockade level of around 1.2 mbpd.
This pickup in production raised questions about oil production which was already facing oversupply. This was something that OPEC+ had to address when making its decision about whether to extend the production cuts to 2021. Thus, in December, in order to accommodate the rise in Libyan production as well as the low oil prices in general, OPEC+ agreed to increase output levels by much less than in its original plan.
Looking forward to Q1 2021, it is possible for Libya to keep increasing its oil output by as much as 300,000 barrels per day, according to the IEA. However, currently the situation remains fragile.
The two most important geopolitical factors at the moment and going into 2021 are the new president in the U.S. and Libya’s pickup in production. The Biden administration could make decisions for a greener future, and we may see the U.S. returning to the Iran nuclear deal. Libya is currently producing oil quite close to the level that it was before the blockade (around 1.28 mbpd). The situation remains fragile.
Oil price forecast (average)
Please note that the forecast is the AVERAGE price per quarter. Thus, prices during the quarter will likely be both higher and lower.
Brent forecast and prices (USD per barrel)
The environmental regulation initiated in the shipping industry to reduce carbon intensity by 40% before 2030 and 70% before 2050 has brought much focus on how to bring down carbon output for the shipping industry. As the current technology is insufficient to comply with the 2030 regulation, much attention has been on LNG, Ammonia, and Hydrogen as possible solutions. However, with these fuels still in their early years of development it seems unlikely that they are going to have an impact on carbon output before 2030 where the first regulation objective is set. This means that it probably will be some years before these fuels are fully operating but what initiatives are being taken to comply with the regulation?
Within operations and technology, the industry is exploring new fuels as mentioned above, but also other ways to reduce carbon output such as carbon capture, slow steaming, scrubbers and efficient vessel design. With some of those already at work with more to follow, these “hacks” will help the industry towards the 2030 goal.
Within policy, industry bodies and governments are pushing for more regulation meaning that companies will have to pay for their carbon emissions. The European Union (EU) is expected to push for an Emission Trading Scheme as the one we saw in aviation in 2012 which along with other initiatives will help the shipping industry on the path to the 2030 goal.
In December of 2020, an initiative was presented by the EU commission on how the shipping industry can become carbon neutral in 2050 and how it can work on realising that goal. The initiative acknowledges the difficulty of this path due to factors such as missing technologies, the competition, and the required investments. A key point in the initiative is that European ports must be made greener, e.g. by docking ships using green energy instead of burning fuel, while moving more transport onto ships from road have proved difficult. The commission also restates its plan for introducing carbon quotas in the shipping industry.
The main problem with many of the solutions currently available is the fact that they don’t deal with the actual problem because these are not carbon neutral solutions which means that carbon is still produced and emitted although in smaller volumes. However, with no viable solution for carbon neutral fuels right now, these “hacks” are the only paths available in the industry although research for viable alternatives to fossil fuels continues.
In the past year, energy markets have experienced one of the most volatile periods in history. When the covid-19 virus spread in the spring of 2020, economic activity was brought to a standstill due to lockdowns and travel restrictions which influenced energy prices massively. Such extreme volatility obviously creates a challenge for oil market participants but as we will see below, there are still ways to implement an effective hedging strategy under these conditions.
One of the most affected industries has been aviation which experienced an almost complete shutdown of business due to travel restrictions. This impacted their hedging strategies as they lost revenues through a loss of operating income and faced uncertainty on not only the jet fuel price but on the volumes now required for their future.
In shipping, commercial segments such as tankers and bulk carriers have been less affected and have continued to hedge throughout this period, especially in the short term. However, the people carriers have been more affected because of travel restrictions for both ferry lines and cruise lines. As the world starts to open again, ferry lines are starting to put hedges in place for 2021 but cruise lines remain much affected by covid-19.
Agriculture companies have remained very active in hedging particularly when the market dropped in the spring of 2020. Furthermore, hedges for producers and manufacturers are also picking up indicating the return of economic activity.
For suppliers and inventory holders, the contango market, where futures contracts are trading higher than the spot price, enables them to protect their inventories by selling the futures contracts which are profitable despite the storage and funding costs.
In general, each industry has been affected differently by covid-19, but the large market movements require a high level of flexibility in terms of reacting to such extreme events. At Global Risk Management we have worked closely with our clients to restructure their hedges and guide them through this turbulent time. This might mean rolling forward hedges to later periods, where their consumption is needed, but also the use of the other instruments as a complement to the traditional swaps, such as options, which give the holder the right but not the obligation to buy/sell and energy product at maturity. This way, companies can protect themselves against extreme price movements without locking in fixed prices on larger volumes which has been an issue for the airlines this year.