By Aaron Putham
- Crude oil demand destruction caused by COVID-19 is expected to be the largest on record, which has created concern about where to store all the unused oil
- At this stage the only cure for low oil prices will be low oil prices
- Over the next 12-18 months, the opportunity to play a rebound is more compelling in individual equities and credit market than crude itself
The View
Oil fundamentals are undoubtedly bearish. Although one may be tempted to think this is already in the price, given crude is down over 60% YTD and at multi-decade lows, the nature of this particular shock keeps short-term risks skewed to the downside. This crisis has a direct impact on the transportation sector, which represents 65% global crude demand and will be substantially depressed in the near term. Prompt WTI prices are unlikely to sustain levels above $30/barrel(bbl) through autumn of this year and we could reasonably touch $10/bbl at some point in the upcoming months.
Why are commodities different than equities?
Looking back at the last six recessions, equities tended to bottom about five months before the end of the recessions as markets discount the turn in economic data before it actually happens. However, broad commodities tend to trough around the same time the recession ends. In other words, equities are more forward-looking while commodities need to see proof, and therefore lag behind. In this particular recession driven by COVID-19 uncertainties, data begins to reflect the current demand shock, so expectations for GDP, employment, and inflation will all begin to decline at a record-setting pace over the coming months. Specific to crude, the movement of physical oil takes time and the expected inventory builds that are currently driving prices lower have yet to show up in the high frequency data. The weekly Department of Energy total inventory data actually has crude oil inventories building at a slower pace than the average of the past 5 years. Until the market can better understand the size and duration of the inventory builds, prices will remain under pressure.
The world is drowning in crude: a look at current demand and supply
With an overflow of crude oil supply, market participants are currently grappling with the reality that traditional crude oil storage capacity may be filled as early as the third quarter this year. The cause of this anxiety is an unprecedented decline in demand over the course of the second quarter which implies that full demand could contract at nearly 3 times greater than it did during the Global Financial Crisis. In just the last two weeks, global air traffic has declined by ~40%, traffic congestion levels have fallen ~75%, and train travel has fallen sharply. Pinpointing the precise demand destruction with accuracy amidst a global pandemic is nearly impossible but the market currently estimates that the demand could decline by nearly 20mb/d (a 20% decline) in April alone. For the full year, demand is likely to decline between3-5mb/d – the largest on record. This type of demand destruction dwarfs what’s happening on the supply side of crude markets. That said, it’s still important to understand the current dynamics at play across the largest crude producers. Following the breakdown in negotiations between OPEC+ countries earlier this month, Saudi Arabia and Russia have ignited an all-out price war in an effort to gain market share. At the same time, US production is unlikely to see material declines for 3-6 months. With the large imbalance between demand and supply, inventories are estimated to build by approximately 1-1.5 billion barrels- as much as a 50% increase in existing stocks. Estimates of spare commercial storage capacity come in around 1.5 billion barrels.
At this stage, the only cure for low oil prices will be low oil prices. Oil prices may need to decline towards $10/bbl such that they are low enough below marginal production costs to force shut-ins of already producing fields.
Signals to watch to call a turning point in crude oil?
On demand:
- US gasoline consumption is the most important factor to follow, as it accounts for roughly 10% of global oil demand. In America, nearly 30% of total vehicle miles traveled stem from commuting to and from work.
- Traffic congestion statistics are another important factor, with estimates suggesting that traffic congestion has fallen by over 75% in many major American cities. This is incredibly important for demand; the top-10 states comprises over 50% of consumption. Simply getting back to work should help support demand.
- There are roughly 350 million barrels of strategic petroleum reserves capacity.
- Overall monetary and fiscal stimulus will eventually feed through to a bounce back in demand – in a typical environment every dollar decline in the price of crude should increase by 46kb/d (thousands of barrels per day). The demand surge in 2021 should be unparalleled when these packages take major effect.
On supply:
- Diplomatic efforts between US, Russia and Saudi Arabia. In the current state, the chances of a production deal being struck are low but it is interesting to see that heads of state have started to have some discussions about this low price environment.
- Liquidity and stress across the high yield energy sector-will high defaults realize sooner than expected and how fast will that feed through to production declines?
OIL HEADLINES over the weekend: Saudi Arabia, Russia and other large producers are racing to negotiate a deal to stem the historic price crash, and some progress was made on Sunday. Talks still face significant obstacles: a meeting of producers from OPEC+ and beyond is tentatively scheduled for Thursday. Russia and Saudi Arabia want the U.S. to join in, but Trump has so far shown little willingness. Oil diplomats are trying to stitch together a meeting of G20 energy ministers for Friday as part of the efforts to bring the U.S. on board. While a cut would reduce the extreme tail risk of $10 crude, the demand overhang is still expected to eclipse any of the proposed reductions in supply. This will be a demand driven recovery, not a supply one. □
Work Cited
- Image source
- Chung, J. (2020, April 8). Oil prices jump on hopes for OPEC, Russia meeting on output cuts. Retrieved from https://www.reuters.com/article/us-global-oil/oil-prices-jump-as-focus-swivels-to-opec-russia-meeting-on-output-cuts-idUSKBN21Q03S
- Defterios, J. (2020, March 9). Why oil prices are crashing and what it means. Retrieved from https://www.cnn.com/2020/03/09/business/oil-price-crash-explainer/index.html
- Hirtenstein, A., & Toy, S. (2020, April 1). Oil Prices Drop on Increasing Stockpiles, Demand Fears. Retrieved from https://www.wsj.com/articles/oil-prices-drop-as-saudi-arabia-boosts-supply-11585749616
- Krauss, C., & Reed, S. (2020, March 8). Oil Prices Dive as Saudi Arabia Takes Aim at Russian Production. Retrieved from https://www.nytimes.com/2020/03/08/business/saudi-arabia-oil-prices.html
- Wallace, J. (2020, April 7). Amid Price War, Texas Oil Patch Is Coming Up Empty. Retrieved from https://foreignpolicy.com/2020/04/07/price-war-texas-oil-patch-coronavirus-pandemic/
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