From Global Risk Management
The Oil Market Quarterly Outlook July'20
After heavy setbacks in the first quarter of this year, oil prices have almost doubled in the second quarter of 2020. Still, prices are considerably lower than in the beginning of the year, before the coronavirus pandemic disrupted both the financial and the oil markets and the previous production cut deal expired.
Most of the world was sent into lockdown as the coronavirus spread and the halt in activities sent oil prices in a downwards spiral as demand for oil dwindled. Early in the second quarter, OPEC and a number of non-OPEC oil producers agreed to cut production heavily which helped put a floor under prices. As the world is beginning to open up gradually, demand for oil is picking up and along with the effect of the oil production cuts, oil prices increased in the last part of the second quarter.
In our report we give our take on fundamental, economic and geopolitical factors which influence oil prices and you will read that we set all three factors as bearish for oil prices, at least in the short term. Much uncertainty remains as regards how fast the world will reopen and activities will return to pre-corona levels and hence how fast oil prices will recover as well.
The last quarter saw a historic deal between some of the largest oil producers in the world as OPEC+ members were able to agree on major output cuts. Demand has been very low during the last quarter because of the coronavirus leading to large increases in oil inventories and large declines in prices. In the below, we will focus on the factors driving both supply and demand in the oil market.
In March, as an OPEC+ deal to cut production expired, led to Saudi Arabia slashing its prices and increasing its production from just under 10 mb/d to almost 12 mb/d in April as can be seen from the graph below. This affected oil prices which saw massive declines in late March because supply levels were way above demand levels in this period. However, on April 12, the parties involved in OPEC+ were able to reach an agreement cutting the output by 9.7 mb/d in May and June, equivalent to almost 10% of world demand, which also shows in the graph below. Russia and Saudi Arabia have lowered their production levels to 9.4 mb/d and 8.6 mb/d, respectively, while other members in the alliance lowered their production as well.
However, some members of OPEC+ have not been complying to the agreed output cuts during May, among them Iraq, Nigeria, and Angola. This caused some uncertainty about an extension of the deal further into 2020 as leading oil producers wanted all members to comply to the agreed production cuts. An agreement to extend the production cuts through July was made in early June dependent on shirking members upholding their production cuts and compensating for missed compliance in May. The missed compliance from some members raises some uncertainty about the deal in the future which we will comment upon later in the geopolitics section.
The low prices observed between March and May have especially affected the U.S. shale industry as they need prices around $50 a barrel to break-even. With prices around $20 a barrel between March and May, prices have been below half of what American producers need in order to cover their costs. Consequently, many American producers have cut down spending with some producers being forced to shut down. Although the WTI crude oil is trading just below $40 at time of writing, Energy Information Administration (EIA) estimates show that this level is not enough to allow for a significant increase in output from the U.S. As the graph below shows, the number of rigs in the U.S. has declined significantly since March to a level below 200 at time of writing. Output from the U.S. is expected to drop by almost 1.5 mb/d in June which contributes to the decline in output initiated by OPEC+.
The missing investments from the U.S. shale industry could have further implications for the supply of oil in the future along with investment from conventional producers all over the world. Producers must invest in new rigs to keep the supply levels stable as the output from rigs over time automatically will decrease by 5% due to the production technology. This implies that the supply over time will decrease by 5% which means that suppliers need to keep investing in new rigs to keep supply levels stable.. It takes a massive investment to initiate the drilling and 20-30 years before an offshoring starts to pay off for the producers, but they can at best only hedge the risk 5-10 years out. So in the current low price environment, producers are hesitant to take on that risk and this fact could affect supply levels in the not so distant future.
The slow implementation of supply cuts from the producers around the world has led to large amounts of oil stacking up in inventories during this period. From the graph below, we can see that U.S. crude inventories have increased massively from March to May as there were fewer buyers of the oil being produced. From the start of 2020, U.S. crude inventories have increased from around 425 million barrels to almost 550 almost barrels. In May and June, we can observe that the building inventories have slowed down as demand have slowly started to pick up again and the U.S. shale production have scaled back as explained earlier.
On April 20, we saw a negative oil price for the first time in history as the WTI crude oil dropped almost 300% to around minus $37 a barrel. This meant that producers were paying buyers for taking their oil. Owners of WTI crude futures contracts came into trouble as they are expected to take delivery of the physical when the contract expires. As the low demand had already filled up the inventories, owners of May WTI crude futures contracts needed to get out of their positions because the contract expired on April 21. With limited place to store the oil and high storage costs, WTI futures owners were willing to go far to get out of their positions resulting in a large sell-off around the last trade day of the May contract. This led to a negative price of the WTI futures contract on April 20. Since then, both the WTI and Brent have increased with WTI showing the best month on record in May as it increased around 90%. Exchanges and index providers have since taken comprehensive measures to avoid a negative settlement in the future.
As we have mentioned in previous reports, global demand for oil have dropped massively during Q2 of 2020. The EIA estimates that the demand for petroleum and liquid fuels will average 83.9 mb/d in Q2 of 2020, down 16.6 mb/d compared to the same period last year whereas OPEC is estimating a decline of 17.3 mb/d compared to Q2 of last year. The graph below shows the large drop in world demand for crude oil where we can see the decline starting in last month of 2019 as the coronavirus emerged in China putting the country into lockdown relatively quickly. As the virus spread through Q1 and Q2 of 2020, demand has taken an even larger drop by almost 20% compared to the levels observed before the coronavirus. The large drop in demand shows the unprecedented situation the world is in right now as we observe rather stable demand around 100 mb/d before the coronavirus. Furthermore, the graph shows a small recovery in May which most likely comes from the fact that some economies are starting to ease lockdowns, increasing the consumption of oil and hence increasing demand.
The major drop in demand in Q2 will affect the demand for the whole year of 2020 with estimates of the largest demand decline in history. According to the International Energy Agency (IEA), global oil demand is set to fall by 8.1 mb/d in 2020 before increasing by 5.7 mb/d in 2021 leaving the total world demand 2.4 mb/d below the levels of 2019. The EIA predicts global demand for 2020 to be down 8.3 mb/d before rebounding by 7.2 mb/d in 2021 leaving a more optimistic view on the demand to pick up in 2021. OPEC estimates global oil demand to decrease by 9.1 mb/d in 2020 but does not have an estimate for 2021 due to the high uncertainty regarding the coronavirus. Consensus seems to be a major hit to demand in 2020, but an increase in 2021 although with different estimates of how much demand will pick up and a lot of uncertainty due to the continuing impact from the coronavirus.
However, demand throughout the coronavirus lockdown has not been as low as feared due to a quicker than expected recovery in China and India. In China, demand in April was almost back to levels pre-coronavirus while India saw a strong rebound in May although not up to levels seen before the coronavirus. Some uncertainty remains how other parts of the world will recover from this point on as there has been an increase in the number of new cases in late June, especially in the U.S. This has increased the fear of a second wave of infections which potentially could put some nations into lockdown again.
One of the main reasons for the drop in demand is found in the aviation sector where most planes have been grounded throughout the coronavirus lockdowns. Data from International Air Transport Association shows that air traffic will fall by almost 55% in 2020 implying a fall in the demand for jet fuel of around 3 mb/d. Furthermore, analysts predict that it will take years for the aviation industry to get back to normal standards of air travel for several reasons which imply a low demand for jet fuel in the coming years as well.
As there is still a lot of uncertainty regarding the economic outlook following the coronavirus, the outlook for demand also remains very uncertain. Demand in the last half of 2020 depends on how the nations around the world exit the coronavirus lockdowns as a fast recovery will result in demand quickly picking up even more whereas a second wave of infections could hold demand down for some time to come.
The deal between OPEC+ members have brought some stability into the market after some very volatile months during the coronavirus pandemic. Demand has seen a huge drop this quarter affecting the annual demand to decline by the largest amount in history but is expected to increase again in 2021 depending on how economies recover after the coronavirus. Due to the large uncertainty regarding demand and the fact that supply is still higher than demand despite output cuts by OPEC+, we set the fundamentals to slightly bearish.
"We set fundamentals to bearish in the short term"
Data from the biggest economies around the world shows signs of deterioration as the midst from Coronavirus seems to settle down. The immediate financial implications and overall economic impacts will be analysed in this section with a focus on USA, Europe and China. Accordingly, a suggestion [JFJ1] of the financial situation and its inherent impact on oil prices will be made. Finally, contemplations on potential future worrisome economic outcomes will be discussed.
The U.S. has seen some of its worst economic months since the great depression with unemployment rates plummeting, GDP growth declining and PMI numbers all the same.
The GDP growth in the U.S. has seen a sharp decline coming from an increase of 2.3% in January 2020 to only an increase of 0.3% in Q1. This number is likely to deteriorate even further when the next set of data becomes available. The initial decline is, needless to stay, ascended from the coronavirus lockdown procedures as businesses had shut down production, closed down services and in general lost revenue as consumers haven’t been spending as usual. The usual GDP target for the U.S. is somewhere around 3%.
The current PMI levels in the U.S. has seen sharp declines as well with current data showing a PMI level that is significantly lower than the critical level of 50. Any situation where the PMI level is lower than 50 is a sign of a retracting economy. The current U.S. PMI numbers is leveling around a number approximating 43. The sharp decline in PMI can to some degree be contributed to the coronavirus, however as depicted by the graph, the PMI numbers in the U.S. has been moving between lower 50 levels and higher 50 levels since the middle of July last year.
The data on GDP growth and the current PMI level suggests a less optimistic picture for the U.S. and the unemployment numbers do as well. Since March we have seen the highest number of jobless claims since The Great Depression with claims rising to approximately 20 million[JFJ1] . Since its peak in April of 14.1% the rate has since dropped to 13.3%, however still being 3 times that of the level before the crisis. The increase is depicted in the graph. Beside the more obvious economic effects of high unemployment such as lower consumer spending, there are additional side effects such as the mental and physical health of the unemployed and the loss of skills. These are key issues that the U.S. is facing in the recovery of the economy.
As suggested in the fact box, the Fed has different tools in its belt in order to stimulate the economy according to the environment in which we find ourselves. As depicted in the Fed Interest rate graph, the interest rates have been lowered to almost 0 in order to stimulate the economy and kickstart investments. As the interest rate goes lower, the incentive to invest should increase as capital becomes less expensive. The effects from a lowering of the interest rate isn’t immediate thus we will have to wait to be able to conclude on the effectiveness of the lowering. Nonetheless, the decrease of the interest in itself is a practical display that drastic times call for drastic measures.
Even though much of the economy is hurting, the stock market seems indifferent and find itself at pre-crisis levels already. At the beginning of the outbreak, the S&P 500 initially trended lower than 2018 levels, but did find its way back rather quickly. Some argue that the currents level do not depict the actual economic environment in which we find ourselves, however that doesn’t change the fact that the stock markets have been trending upwards.
As is the case with U.S., Europe seems to find itself in worsening economic condition. The first suggestion is the GDP growth. Before the crisis hit, Europe was indeed already struggling to find its capacity to create GDP growth, a scenario that seems to have only been intensified by the coronavirus. Growth numbers in Europe was around -3% in March. Spain and France both saw economic shrinkage of respectively 5.2% and 5.8%. France has not seen a GDP shrinkage of such a level since 1949. The shrinkage is a combination of the supply and demand effects from the coronavirus, where the supply effect is a loss from a loss in hours worked and the demand is the psychological aspects of the consumer that includes taking precautions against the coronavirus.
The PMI number in Europe has been struggling the last year as well indicating a recession like economy for more than a year. During the coronavirus the number has dropped even further to a low of 33, but has since regained some traction, however still way below the lower limit of 50. Moreover, compared to U.S. numbers, the European numbers still seem to show a worse economic conundrum.
A sign of amelioration within the European economy has been its steady decline in unemployment throughout the last 6 years. The trend, however, was abruptly broken by the coronavirus, as the graph depicts. However, the furlough schemes from European countries have secured a minimum increase in the unemployment rate. Compared to the U.S., which has seen an increase from 3% to 13%, the European countries has effectively ensured job capacity for now. The furlough scheme might indeed save the European countries from having to deal with the complex side effects that the U.S. face, but that is still unsure. There is no securement of job offers as the furlough schemes end businesses have to pay workers again, thus leading to speculations if jobless claims will skyrocket. The OECD expects the European unemployment rate to increase to 10% by the end of June.
Europe has for a long time been operating with negative interest rates to boost the economy. Thus far, the negative interest rates haven’t been as effective as theorized, which is why the ECB has initiated quantitative easing programs. This is partly due to a lack of fiscal spending by governments. It is, however, hard to contemplate where the European economy would be today if the ECB had not commenced with negative interest rates in 2014, and thus it seems undue to conclude on the exact effectiveness of the negative rates. Nonetheless, negative interest rates inherit several issues in the long-run. First off, people are starting to experience losses in their retirement savings as negative interest rates encourages cheap spending but expensive savings. Moreover, once the ECB crossed the border in going from positive interest rates to negative interest rates it seemingly ran out of traditional monetary options in boosting the economy further insofar the negative interest rates didn’t work as theorized, i.e. didn’t boost the economy enough. This is also the reason why we haven’t seen a sharp decrease in interest rates from the ECB during the coronavirus, as a lowering of a negative rate simply will not have any real effect. The ECB has been trying with non-traditional monetary policies such as quantitative easing programs to boost the economy further, which has seen some success. However, in facing the coronavirus the ECB introduced a new form of non-standard monetary policy with its PEPP scheme, which is asset purchase program that in effect is a quantitative easing program, that set out to buy back assets of €1.350 billion to ease the pressure on the European economy.
China was he first country to be affected by the global pandemic and the economic data shows signs in line with what we saw from both Europe and the U.S. GDP growth has declined to -10% from an expected increase of around 2%. In May the Chinese government issued a statement that it wouldn’t set a growth target for the rest of 2020 amidst the coronavirus, which creates high amounts of uncertainty.
At the same time we witnessed China experiencing an significant loss in their PMI index to record low levels of 35.7 as the Chinese government issued lockdowns and quarantines to contain the coronavirus. The downturn was corrected rather quickly to pre-crisis levels of over 50. China’s National bureau of Statistics wrote that “sub-indices for production, new orders and employment expanded” which was the reason for the quick correction of the PMI.
As the major economies around the world are massively affected by the coronavirus which has shut down most countries, central banks and governments are doing everything in their power to support the economy. With Europe already heavily affected and Chinese growth slowing down, the coronavirus will hit all economies. Whether interference from governments and central banks will be able to get economies back to normal within a short timeframe remains uncertain and the question remains how long before economies recover from the recession created by the coronavirus. With this in mind, we set the financials to bearish.
"We set financials to bearish"
The oil price war / OPEC+ deal
As the coronavirus spread around the world resulting in the largest demand drop in history, Russia, Saudi Arabia, and the rest of OPEC+ could not agree on supply cuts to balance the market at first, but managed to do so in April. As mentioned earlier, an extension of the deal through July was made dependent on shirking members complying to their expected production cuts and compensating for missed compliance in May. This could add some risk to the deal because the extension is dependent on all members complying 100% which has rarely happened in OPEC+’s 3.5-year history. Some members, among them shirking nations like Iraq and Nigeria, are very dependent on oil export to fund their budgets. The question then remains whether members will uphold the deal which some analysts are skeptical of for the above reason. If shirking nations fail to uphold their end of the agreement the whole deal could blow up as Russia and Saudi Arabia have no interest in being the only ones cutting down on output. Such a situation could prove critical for the oil market at a time where demand is so low leading to a situation much like the one observed in March and April.
The U.S. and Iran conflict
In the previous year, the conflict between the U.S. and Iran has escalated multiple times. In June 2019 when Iran shot down a U.S. drone, in September 2019 when Iran was accused of the attack on the Saudi oil infrastructure, and in January 2020 when the U.S. killed an Iranian general. Previously, the U.S. has imposed economic sanctions on Iran in an attempt to unarm their nuclear weapons and these sanctions have hurt Iranian economy with one of the reasons being a decrease in oil exports as other nations through the years have followed U.S. advice and started buying oil elsewhere. The last quarter has seen an ease of tensions in the midst of the coronavirus that has taken almost all attention, but an escalation of the conflict could have consequences for oil supply. Fear of an escalation is still present in the markets due to the pressure on the Iranian economy from the sanctions imposed by the U.S.
"We set geopolitics to bearish in the short term"
A lot of uncertainty rules the landscape of oil and will continue to do so the coming years. Environmental and geopolitical factors seem to be the main drivers behind this uncertainty. Shale drillers are experiencing difficulties financing their drilling expenses as capital is being withhold due to concerns of climate change. In general, conventional upstream projects have faced a chronic lack of investment since 2014. A withholding of capital today will inevitably lead to lower production at a later time. The uncertainty for the future of oil also has its implication on conventional oil drillings as it usually takes 20-30 years from implementation before a drilling platform makes its investment back. In the current environment of uncertainty that is a long time and the steep time horizon might indeed scare investors away from establishing new drilling platforms. This issue is currently displayed in the decrease in conventional wells, which is seeing a decline of around 5% per year. In comparison, shale producers is experiencing a decline of 70% a year. Moreover, in the midst of the coronavirus, many producers have seen it necessary to stop production fully as the world saw storage running at near full capacity, as demand for oil declined sharply. Some of the producers will have a hard time getting production up to pre-coronavirus levels. These factors combined could be indicating a future where production will be much lower than what consumers are demanding.
There is no immediate reason for demand to decline in the coming years as the need for energy to develop remains regardless of political incentives. IMF has recently predicted an oil peak demand in 2040, which is a long way from now, but almost not enough for oil drillers to make back their investment in drilling platforms. On a short time horizon however, there is no prompt technology that can deliver the vast amount of energy that oil does. This has led large players to suggest that we will see a heavy price spike in oil in the coming years, with suggestions as high as $190/barrel in 2025, with steady increases in oil prices from 2022 when the supply. deficit will become apparent.
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.
How is the report structured?
The report is divided into three parts – each part elaborates on three main topics which are influencing the oil prices:
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