Oil Has Recovered From Record Lows But $40 Prices Unlikely Before Q3 2020
by Gaurav Sharma
You could be forgiven for being a little foxed with oil market right now, especially if the West Texas Intermediate (WTI) is your preferred futures benchmark to monitor. On April 20 ahead of the expiry of the May contract, it suffered the ignominy of negative oil prices.
It eventually closed for the first time in trading history at -$37 per barrel as the global coronavirus or Covid-19 pandemic left paper traders dangling contracts of unwanted oil they had little capacity to shift. Yet, rather spectacularly by May 21 – with trading on the WTI July contract in full swing – the benchmark closed at $33.92 per barrel.
In mathematical terms, that's a reversal in fortune of over $70 in the space of a month. You can consider that to be a circumstantial aberration but global proxy benchmark Brent is also back above the $30 level, making it the first such instance in two months that both major benchmarks have traded above the psychologically pleasing level.
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So is the worst behind us and the only way is up? Answer it not quite so simple as there are several caveats to a straight cut yes or no quip. Near-term negativity related to oversupply and the short-lived chaos of the collapse of OPEC+ has turned into a 9.7 million barrels per day (bpd) cut effective May 1, various countries are easing Covid-19 lockdowns, and China's keenly watched demand is up. Bejing's import are currently averaging a more normal-looking 13 million bpd, according to Reuters.
So the worst maybe behind us for now, discounting any second wave of Covid-19 infections, but depressed demand will remain a feature of the market for the remainder of the quarter as aviation remains in the doldrums.
As for the oil price – the only way is not up, not yet. The new normal is likely to be around $40 per barrel; and while oil futures are not that far off the said level a whole lot of normalization is needed before that happens.
In 2019, global demand averaged 99.67 million bpd. The figure has been nearly matched in recent trading sessions, but that's after a depressed March and dire April. It is quite likely that 2020 will end 9.3 to 15 million bpd below last year's average. That's a nullification of 10 years of demand growth, and while it won't take another decade to get back to their again, the next few months are unlikely to reverse the damage to 2020.
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General expectations over demand also need to be tempered, Covid-19 or not. The worst of the pandemic is behind China but its public relations fallout continues, as does its trade tiff with the U.S. and escalation of global tensions over Hong Kong.
OECD crude oil demand was already weak before Covid-19 hit and it will remain so especially in the case of automotive. Furthermore, every market indicator seems to point to India, Japan and South Korea importing less and domino effect of a global recession is yet to be countenanced too.
Expectations over the decline in global production also appear to be exaggerated, especially in the case of U.S. production levels. There will be, and already is, distress in the U.S. shale industry and bankruptcies will rise but a $30+ price levels keeps many in the game. The most pessimistic oil production decline forecast models suggest the U.S. will lose 1.75 million bpd in production.
That would still put the country's headline output around 11 million bpd, well below January 2020 levels of 12.74 million bpd but comfortably placing the U.S. among the world's leading producers capable of dispatching substantial volumes of oil, especially light sweet crude, to Asian markets.
Current prices, especially if they inch up and flatten $40 later this year, are likely to test OPEC+ discipline too. Put it altogether there are plenty of near-term factors that could prevent an overshoot beyond the as yet-to-be-reached normal of $40+ oil prices ahead of a clearer Q3 picture.
Ample proof of the new normal is being provided by the narrowing of the Brent-WTI spread; currently well below a $2 per barrel premium in Brent’s favor. WTI contango - i.e. a market structure indicative of trading sentiment in favor of oil prices being higher in the future compared to current prices – which was at record levels unseen since the height of the global financial crisis in January 2009 has all but evaporated in relation to six month forward contracts.
WTI January [2021] traded at $35.78 and February [2021] at $36.05 against the current and actively traded July contract price of $33.72 at 13:00pm EDT on Monday (May 25). It equates to less than a fourth of the $12 premiums recorded on March 29. That's not to dispute that $40 won't be the reality for both WTI and Brent; but rather that it may not arrive well into Q3 and might swiftly become the new normal for the remainder of the trading year.