From Global Risk Management
The Oil Market Quarterly Outlook October'20
The world as we know it remains disrupted. As the Covid-19 pandemic rages around the world, affecting global trade and economic activity, it is causing huge uncertainty in our demand for oil and other energy sources. Travel restrictions, including country and local shutdowns, heavily influenced oil prices in Q3 and will likely do the same in Q4, potentially even longer.
The dark horse in all this is a cure or vaccine against the Covid-19 virus, which has been a hot topic and a great need for months. Also of concern is the OPEC+ oil production cut agreement, which is in place for the rest of the year; and asks the question if it is sufficient to keep oil prices from plummeting further. U.S. oil production has declined further along with oil prices as oil drillers struggle to remain profitable in the higher costs shale basins. Lastly, at the time of writing, oil output in Libya is on the rise though the political situation remains fragile.
The global oil markets continue to be heavily influenced by the coronavirus situation around the world as demand remains very uncertain going into Q4 and while major supply cuts from some of the largest producers are still in place. In this section we will focus on the main drivers for supply and demand in the oil market.
Following the large drop in demand due to coronavirus lockdowns, OPEC+ members agreed to cut output from May by 9.7 mb/d equivalent to almost 10% of world supply as mentioned in the previous report. Production numbers from other large suppliers was lowered as well, among them the U.S., which helped the oil market come to some sort of balance as prices found some support after the drop in April. From the graph below we can see that the output levels from OPEC as well as other large producers such as Russia and the U.S. have declined rather significantly compared to pre-virus levels and the level in April where Saudi Arabia and Russia were competing for market share.
In July, OPEC+ members decided to ease the supply cuts from the original 9.7 mb/d to around 7.7 mb/d starting August as the alliance saw demand recover over the summer months. However, as some nations hadn’t complied with the original agreement, the Energy Minister of Saudi Arabia announced that the cuts should still be higher than 7.7 mb/d as shirking nations were to make up for missed compliance. The missed compliance from some OPEC member is a recurring problem as nations including Iraq, Nigeria, Angola and others have been an issue since the supply cuts agreement came about in April.
As can be seen from the graph below, the previous mentioned nations started to comply with the supply cuts over the summer as their production has been decreasing. The rebalancing effort from OPEC+ is highly dependent on full compliance from all members as has been stressed multiple times from Saudi Arabia and Russia, especially lately where demand outlooks remains weak. The current supply cuts of 7.7 mb/d are set to run until the end of this year with the next OPEC+ meeting scheduled for December. However, OPEC has claimed the commitment to take further actions should it be necessary dependent on the development in demand throughout the year.
The lower oil prices, which came as a result of a decline in demand, have had large consequences for the U.S. shale industry with American producers cutting down spending and being forced to shut down wells. This can be seen from the number of active rigs in the U.S. in the graph below where the number of active rigs dropped from around 700 to below 200 in a matter of months. Since then, the number of active rigs has been stable at around 200 which indicates that U.S. producers don’t see demand picking up anytime soon. Although production picked up a bit over the summer as demand rose, the outlooks have worsened again, potentially leading to a decrease in the production from U.S. producers. In the future, U.S. production will likely take some time before reaching previous levels of production. According to the EIA, new drilling activity will likely not be able to offset the decline rates from existing wells in the first half of 2021. With the current price for WTI Crude under 50 dollars a barrel, many U.S. producers will be unable to produce above break-even costs.
In a time where the U.S. shale industry is under pressure, the situation worsened further as multiple hurricanes hit the coastline of Texas and Louisiana in late August and September. As a result, many oil and gas platforms in the area were evacuated leading up to the impact of the hurricanes, taking away large parts of the areas’ production several times as each hurricane hit. However, with generally high inventories, the impact of the disruptions in production might not be as large as seen from earlier hurricanes. Typically, the recovery of such incidents takes time, but the newest reports suggest that the impact of most of the hurricanes was not as huge as feared. Not only are the producers affected by such events – several refineries were forced to shut down as well which might help reduce products inventories temporarily.
The supply levels in Libya could be increasing after a blockade of the nation’s oil ports earlier this year slashed the nation’s output from around 1.2 mb/d to around 100,000 barrels a day. As can be seen from the graph below, the production has decreased significantly from the start of the year resulting in exports decreasing similarly as well. The latest reports suggest that a reopening is under way as the Libyan commander Khalifa Haftar is committed to ending the blockade that has been in place for months. The output has already increased from 80,000 barrels a day at the start of September to 300,000 barrels a day at the end of September and some of the closed ports have reopened. As production is increasing, exports should be increasing along with it depending on how quickly producers are able to fix wellheads, storage tanks, and pipelines that may have been damaged during the conflict. Some market analysts predict that production levels could reach 550,000 barrels a day at the end of this year while others suggest that the level could reach 1 million barrels a day this year. With the past 10 years’ of Libyan history in mind, we lean more towards the former than the latter, when it comes to a restart of oil production/export.
The latest demand forecasts show that the Energy Information Administration (EIA) expects the average global demand for 2020 to be 93.1 mb/d which is 8.3 mb/d lower compared to the levels of 2019. while OPEC predicts a drop in demand of 9.5 mb/d. These forecasts have all been revised lower compared to the previous reports showing the large uncertainty regarding demand. For 2021, all three agencies expect the global demand to rebound growing in the range of 5.5-6.5 mb/d compared to the forecast for 2020.
Overall, demand levels have picked up after a period over the summer with easing restrictions from many countries around the world, leading to increases in economic activity and travel. This can be seen from the graph above where the low in April of just above 80 mb/d has increased to almost 95 mb/d in August. However, in the past months, the demand outlook has been rather negative as the number of coronavirus cases continue to surge in many parts of the world.
As the holiday season ended, the number of cases surged in many parts of Europe and now many countries are implementing additional restrictions leading to a decrease in economic activity. Furthermore, working from home, which has been the new normal many places, has affected the use of cars in transportation to and from work further affecting demand.
In India, the number of coronavirus cases has continued to rise dramatically. In September, this led to the largest MoM drop in oil demand from the country since April. Other Asian countries look better regarding coronavirus such as China, Japan, and Korea. However, the demand from such nations remains low as the consumption has not recovered to pre-coronavirus levels and it remains very uncertain when such levels will appear again.
The coronavirus situation in the U.S. remains serious. After a strong rebound in gasoline demand in the summer driving season, the recovery slowed down in August as the season ended. This means weaker demand from the U.S. for the rest of the year which will show in inventory levels for the rest of the year.
There remains large uncertainty globally regarding demand as the development of the coronavirus is difficult to predict, affecting economic activity can be seen from the forecasts of OPEC, EIA and IEA showing the most diverse predictions ever over the course of this year. The recovery highly depends on the development of a vaccine and with the uncertainty on how long it will take before we have such a vaccine, the market will continue to be in a fragile state.
As demand outlook is very uncertain due to the continuing impact of coronavirus around the world, the oil market remains in a very fragile state. OPEC+ is still trying to control the supply levels to keep the market in some sort of balance but they are dependent on members complying to the expected quotas whereas the U.S. production is lower due to lower prices.
"We set fundamentals to bearish in the short term"
The Financials section of our report will investigate and asses the overall macroeconomic condition as world governments try to fight an unprecedented economic downturn. Furthermore, we will take a look at key economic data points on the world’s largest economies, the U.S., Europe and China.
In our previous report we saw a contraction in GDP from 2.3% in January to 0.3% at the end of Q1. This decline, although steep, fades in comparison to the decline observed from Q1 to Q2, where the GDP numbers tumbled to -8,9% Y-o-Y. This massive contraction is the effect of ongoing containment measurements and a collapse in global trade, which has led to reductions in working hours, job losses and shutdown of businesses. GDP numbers for Q3 will be released by the U.S. government on October 29th. Uncertainty on the development of GDP in the U.S. rules as much political turmoil exists due to the presidential elections in November. Moreover, fiscal stimulus in the U.S. has expired with no news yet of a new package to protect households and businesses.
The U.S. PMI numbers suggest a different outlook than GDP for the coming months as production levels have risen from lows of just over 40 back in April and May to a level of 54.4 at the time of writing. The regeneration of production was a result of new orders and an acceleration of growth at service providers. Manufacturers still outperform service providers in terms of production. The official number for September was 54.4 down 0,2 points from 54.6 in august.
The monetary stimulus which central banks around the world have supplied for their economies will remain important in regenerating the economy. As touched upon in our latest report the U.S. central bank, the Fed, decided to lower interest rates significantly at the end of Q1 to combat the declining economy. The level is currently set at 0,125%, which means that the US have yet to engage in negative interest rates, as Europe has done. The low rate has been carried on through Q2 and Q3 in order to stimulate the economy further. The OECD suggests that stimulus must keep coming and points out that without the stimulus-packages, both fiscal and monetary, the economy would be looking much worse than it is currently. The Fed has announced that the low rates will indeed be kept low the coming years, at least until inflation hits 2% and stays there and employment reaches full capacity again.
Digging deeper into the current unemployment data we see that a correction from our last report has happened with unemployment levels currently circulating around the 8% area, which is approximately 4% higher than the target of, you guessed it, 4%. The quick recovery of jobs has been attributed to stimulus packages and help for small businesses. However, these strategies are seen to be somewhat exhausted. The consensus is that the time horizon for getting the last 4% back into the jobs market is much larger with an expectation of a little under a year.
As is the case with the U.S., Europe is also undergoing a quite dramatic drop in GDP to approximately the same level as the U.S. The worst hit countries in Europe are Spain, the UK and Portugal, who showed Q2 GDP rates (compared with previous quarter) of -18.5%, -20,4% and -14.1% respectively. Some of the better-off countries were Finland, Estonia, Latvia and Lithuania. A large part of the contraction in GDP can be attributed to a decrease in EU household consumption by 12.4% and a decline of 18.8% in exports.
The PMI numbers in Europe seem to have largely been following the same trend as the U.S. with a recovery of production. This can also be attributed to economic packages and fiscal stimulus and gives a clear indication that immediate stimulus has in fact helped the economy to a level that no longer suggest a contraction in the economy – although this does indeed stand in contrast with the observed numbers on GDP and unemployment status.
As we saw in our latest report, Europe has not had the same monetary stimulus opportunities as the U.S. had as the interest rates in Europe were already below 0 before the pandemic came. This has meant that most European countries have relied solely on fiscal stimulus packages and emergency packages to stimulate the economy besides the non-standard monetary stimulus of PEPP, which is set to run until June 2021.
The unemployment levels in Europe never saw such extreme levels as in the U.S. due to the furlough schemes put in place. Many of these schemes are set to carry on for an extended period. Germany and France, two of the largest European economies, will provide furlough at least until the end of 2021.
Even though the unemployment rate might not have increased as much as feared, the hours worked decreased by 12.8% in the euro area and 10.7% in the EU. The decline in hours worked can be interpreted a various number of ways, however the most prominent correlation seems to be an overall decline in demand of services and products by consumers, as touched upon in the European GDP section.
Turning to the Chinese data points we are seeing improved economic outlook as it seems that China has weathered most of its downturn. The first indication of the recovery is the GDP level. China has experienced a v-shape recovery of the GDP level and is, in contrast to Europe and the U.S., experiencing a positive GDP. Several factors have laid the foundation for such a recovery. Inbound foreign investments increased by 18.7% in August, suggesting optimism on the Chinese economy by outside investors. Moreover, China has intiated a number of stimulus policies, which have led to an increase of 29% in lending (household lending was up 11%, while business lending was up 119%).The increase in lending established itself as the PBOC (People’s Bank of China) cut interest rates and provided direct loans to companies affected by the virus.
Along with the v-shaped recovery in GDP, we also see a sharp v-shaped recovery in the Chinese Caixin PMI index, to the point where numbers are better today than they were before the pandemic. This can partly be attributed to a strong investment into real estate and infrastructure projects together with a boost in manufacturing activities. Exports also increased in August which points to stronger consumer demand abroad.
As with the GDP and PMI indices, the outlook for unemployment levels in China never quite was as affected to the extent it was in Europe and the U.S. The reasons can be attributed to the increased optimism on the Chinese economy, together with large stimulus initiatives and increased worldwide consumer demand.
Worldwide financial data shows mixed signals for future economic recovery. The U.S. and Europe seem to be worse off than China, but reassurance can be found in a continuous focus from governments on stimulus packages and real economic help for businesses and workers affected by the pandemic through both fiscal and monetary stimulus. Much uncertainty remains as to the degree of a potential second wave and when a vaccine will come to market.
"We set financials to bearish"
U.S.- China Trade Relations
The U.S. and China are the world’s two largest economies and thereby their mutual trade relationship plays a significant role on the worldwide energy consumption.
These two juggernauts have been in a trade war with each other since 2018, and this has been felt worldwide. In January it seemed as though both countries would ease restrictions on each other. However, in the last six months the relationship has become increasingly stained, as the countries have clashed over various tech-disputes such as TikTok and WeChat. These are only the most recent cases, others include China’s new national security law for Hong Kong, controversy surrounding the Chinese company Huawei and the origins of the coronavirus. In addition to these aforementioned companies the Trump administration has added many more companies to an economic blacklist.
The U.S. has accused China of unfair trading practices and China suspects the U.S. is trying to harm its rise as a global economic power by means of imposing tariffs and taxes on imports from China. In the U.S. there is also a view that it must address challenges from China such as unfair trade practices, alleged failure to protect intellectual property and alleged national security concerns. We are still seeing many U.S. companies committed to participating in the Chinese market however, there is evidence that this relationship is changing. In the first half of this year two-way capital flows fell to its lowest since 2011. It is especially U.S. investments in China that have decreased in the first half of the year as Chinese investments in the U.S. has increased by 38%. This sharp downturn could be due to the general business climate as the world is struggling with a pandemic in addition hereto the recent tensions between the two countries could have resulted in companies holding back on investments.
Regarding supply chain independence we have already seen that three major Asian pacific nations Australia, India and Japan have all launched an initiative to reduce dependence on Chinese manufacturing.
In January China committed to buying $200bn more in U.S. goods and services during 2020 and 2021. This target has been described by many as being unrealistic. An upcoming virtual meeting is likely to determine whether these targets can be met or not. It could be argued that it would be too costly for the two parties to just walk away now.
The upcoming U.S. election is also likely to play a role on future trade relations between the two huge consumers. Both presidential candidates have mentioned that the U.S. should reduce its dependence on Chinese pharmaceuticals, this will take a while. Having a strong dependency on China leaves the U.S. vulnerable and could force the U.S. to engage in retaliatory action on other fronts and thereby creating a potential for an even more disruptive trade conflict. Taking a step back it should be noted that a lot of the U.S. pharmaceutical imports comes from India, which then in turn gets its imports from China!
"We set geopolitics to bearish in the short term"
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.
With recent statements from BP stating that the golden era of oil is over one could stop and think what is going to take its place as the world’s energy demand keeps increasing as well as a need for cleaner burning fuels.
Liquefied Natural Gas (LNG) is a strong contender in the short to intermediate term, to become a more prolific energy sour. In 2019 the global LNG demand was 356.06 million tons, and this is expected to grow at a compound annual growth rate of 5.8% from 2020 to 2027. Major drivers in the industry are the uncertain fluctuations in oil prices as well as favorable government regulations.
Increased investments in support and expansion of the infrastructure in developing, as well as developed, countries are expected to lead to an increase in supply of LNG. However, due to the vast costs associated with the development of such projects pipeline infrastructure will almost certainly be inadequate in more remote regions. Power related projects, such as petrochemicals and city gas distribution are expected to result in an increase in LNG demand in the coming years.
As with almost all energy products we must look to how the U.S. market is looking at the LNG market. During the last 10 years we have seen a vivid transformation in the north American natural gas (NG) market, as prices have fallen, and production has increased significantly. This increase has mostly been driven by the success of extraction unconventional gas, especially in the Utica and Marcellus shale in Appalachia. In order for the U.S. to build a sustainable natural gas export industry, producers will need to produce at low prices at the same time as they finance additional capital to explore and drill more wells but also potentially by gaining operational efficiencies.
In the near future drivers of supply growth for LNG are shale production in the United States as well as large conventional projects across Russia and the Middle East. However, these projects are under pressure from the recent drop in oil prices as well as the uncertainty of demand in the near future. Slower growth in worldwide gas demand in the upcoming years is expected to counterbalance LNG imports in the future and thereby mitigates the risk of a tight LNG market for the time being.
The market is segmented according to application and these are mostly transportation fuel, power generation and others. In 2019 power generation accounted for the lion’s share at 47.1%. Transportation is expected to see a significant rise in the coming years as the use in vehicles across Europe and China grows. This will be split between electric vehicles and possible CNG cars.
At a quick glance, one could assume Q3 volatility has been relatively low when compared with the previous 2 quarters. This has been the case for front month ICE Brent futures contracts, starting Q3 a few cents over $41/bbl, reaching a high at the end of August just under $46/bbl before sliding off on the increased risks of regional lock downs, and a cessation in Chinese buying of various crude grades for SPRs, looking to end the quarter roughly where it began around $42/bbl.
However, this is far from the complete story for the oil complex, as several sub plots across the barrel have been playing out in the products markets.
The villain of the products markets has been and remains to be ULSD. Despite a perceived recovery, stocks have remained stubbornly high across all regions, floating storage economics work to sail new build VLCCs from Asia to Europe and leave them anchored outside ARA, driving the front month diesel crack vs ICE Brent to historical lows, dragging down refinery margins with it as building inventory continues to steal demand from the future. Despite a deeper and longer refinery maintenance program this year vs seasonal averages, there remains no way out for European diesel other than longer-term refinery closures. This is something we are starting to see with several unprofitable refineries looking to be converted to biodiesel plants or storage facilities. Should more of these projects be announced over Q4, future upside for ULSD is possible when a vaccine is administered globally, coupled with fiscal spending. However, with Indian refinery rates set to increase, and increased refining capacity coming online in China in Q4, refinery margins and the oil complex is to remain the antagonized by ULSD.
Although a much smaller market, Jet prices remain below ULSD, offering no respite to the refiner. Q3 saw gains in demand vs the previous quarter in all regions, as holiday makers rushed to make the most out of a brief window in travel restrictions. Yet YoY demand numbers remained significantly lower, with several airlines continuing to cut capacity going into Q4, as it is expected business travel will suffer significantly more than recreational travel, especially as regional lock downs and quarantine measures appear to be increasing again. As with ULSD, Q4 looks torrid for Jet demand, but as other analysts pointed out towards the end of September, should a vaccine be readily available by late Q1/Q2, longer dated jet prices look very cheap by historical metrics.
Q3 has seen the lighter end of the barrel in gasoline and naphtha proceed as the hero of the complex, and while ULSD containment issues look set to remain, so does Ebob and Naphtha strength. The combination of lower refinery runs during the U.S. driving season, a switch from public to private transport, the avoidance of air travel and increased demand for PPE, taking molecules out of the gasoline blending pool, has seen light end cracks go from strength to strength, coupled with falling stocks in all regions. This trend is set to continue, especially with the Chinese Golden Week holiday approaching, with citizens having missed out on seeing family over their Lunar Holiday due to Covid restrictions. Coupled with India coming out of lockdown, eastern demand should continue to rise, as Jakarta looks set to come out of lockdown in Mid-October. With U.S. demand returning quicker than expected refinery outages on the East Coast muting supply, and the prospect of further stimulus cheques imminent in the run up to the November election, this will continue to provide a pull-on molecule from Europe.
Bunkering demand remained resilient throughout Q3, coupled with Middle Eastern cooling demand for HSFO keeping Rotterdam Barges vs ICE Brent at year to date highs throughout the quarter. With tepid refinery run rates subduing supply and an increase container lines being operation trans-Pacific, the outlook for HSFO remains bullish, especially if some of Europe’s more basic refineries become mothballed. VLSFO, or 0.5% looks a lot more precarious. Market share is being lost to HSFO as more scrubbers are installed and enter the market. At just under $4/bbl, the VLSFO crack is currently a refiner’s most profitable product, something which is unsustainable for a mere 2-3mbpd market. This imbalance is further worsened as China looks to create itself a bunkering hub. Any scrubber currently unhedged is only set for a longer payback period.
Headline markets have cast a façade of calmness, while subplots beneath have brewed a never-ending riddle for refinery planners. As we head into Q4, it remains to be seen if Chinese buying for SPRs return and depletion rates in the U.S. shale patches produce significantly less crude than forecast, both further hurting refinery margins, or whether the return of Covid lockdowns once again wreak havoc across energy markets and further afield.
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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