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Trade cautiously in crude, demand may take years to recover

June 02
19:05 2020

Navneet Damani

For the world’s most important commodity, there’s never been a quarter like these with double whammy supply and demand shocks. In an unprecedented event, the NYMEX WTI prompt contract for May plunged to a historic low on 20 April and traded at a negative price for the first time ever, settling at negative $ 37.63/b. This highlighted how investors and traders can react when logistical oil limits are severely tested. Global oil industry witnessed many a shock, but never of this scale. Oils sector witness massive volatility and downturns in this quarter as WTI, the benchmark U.S. crude turned negative. Liquidity became tight for most shale players as prices remained in a downtrend.

The disagreements among key producers on quantities to produce kept the markets on tenterhooks. For now, there’s blatant relief that normal service has returned to the oil market. It is on the supply side where market forces have demonstrated their power and shown that the pain of lower prices
affects all producers.

COVID, which began in Wuhan, turned into a global pandemic with thousands of flights grounded, a direct hit to Jet Fuel, and lockdown leading to empty roads and no demand for gasoline. Demand decreased by 10% this quarter due to these factors.

For this quarter, markets experienced bunch of factors starting from price war between Saudi Arabia and Russia, COVID slowdown and the increasing geopolitical risk in Middle East. The most interesting fact in this quarter was the filling of tankers in Cushing and Oklahoma which were the major trigger for the fall in prices. Yes, the fears of storage tank topping have subsided, which has helped boost prices. But there are still plenty of downside risks to the rally.

COVID, which began in Wuhan, turned into a global pandemic with thousands of flights grounded, a direct hit to Jet Fuel, and lockdown leading to empty roads and no demand for gasoline. Demand decreased by 10% this quarter due to these factors.

For this quarter, markets experienced bunch of factors starting from price war between Saudi Arabia and Russia, COVID slowdown and the increasing geopolitical risk in Middle East. The most interesting fact in this quarter was the filling of tankers in Cushing and Oklahoma which were the major trigger for the fall in prices.

Yes, the fears of storage tank topping have subsided, which has helped boost prices. But there are still plenty of downside risks to the rally. Oil prices are soaring as there are more signs that demand is rising more quickly than many had anticipated and hopes that an economic rebound boom is right around the corner. But a reality check is in order. WTI at $ 30 per barrel is suddenly seen as “bullish,” but that price level is financially unsustainable for a vast swathe of global oil supply, including most
of the US shale complex.

Crude oil was akin to industrial waste in some parts of the world, something you had to pay people to take away. Now prices are surging, up about 70% in New York since the start of May, with WTI for June delivery settled at $ 32.50 a barrel, slightly higher than the price for July.

That’s a clear sign that holders of the expiring front-month contract weren’t fearful of getting stuck with unwanted barrels. It is on the supply side where market forces have demonstrated their power and shown that the pain of lower prices affects all producers.

We are seeing massive cuts in output from countries outside the OPEC+ agreement and the cuts are faster than expected. This group, led by the United States and Canada, saw output in April 3 mb/d lower than at the start of the year. In June, that drop could reach 4 mb/d, with perhaps more to come.

For India, lower crude prices provided some relief on input costs as well as on the current account situation. The market saw some rebound because of the deep supply cuts that negative prices accelerated across the industry, from coordinated reductions by OPEC and Russia to the dramatic slowdown of drilling in the US as snap-back in oil demand comes as OPEC+ is ahead of curve in implementing production cuts. These cuts have been painful for the industry, but they are a necessary step given the collapse in consumption caused by the coronavirus pandemic.

Macroeconomic risks persist for the coming quarters with major European economies headed by Germany are staring at a recession, while an uncertain U.S. economic recovery could stretch through the end of 2021. For now, there is ample positivity.

For this quarter, oil and gas leaders were being forced to consider new ways to adapt to the need of lower price environment. The low interest rates and other fiscal policies helped prices but the recession fears remain in the market with unemployment levels more than 10 times the claim a year prior. OECD growth for 2020 has been revised down sharply by 2% points to stand at – 6.1%, the largest decline these economies have seen on average by far since WWII.

Within the major emerging economies, China experienced a significant decline in 1Q20, given that the economy experienced peak infections earlier than other countries. It had already started to recover in 2Q20. Positive growth will first return in 2H20, when the global economy will be able to absorb Chinese exports. This will lead to economic growth for 2020 in China of 1.3%.

In light of the continuation of some lockdown restrictions in India until mid-May, the economy will face more significant repercussions and is now forecast to decline by 0.2% in 2020. With the severe impact of COVID-19 and ongoing challenges in commodity markets, both Brazil and Russia are now forecast to decline considerably in 2020, by 6.0% and 4.5%, respectively.

Demand:

Oil demand was also hit strongly, down nearly 5% in the first quarter, mostly by curtailment in mobility and aviation, which account for nearly 60% of global oil demand. The COVID-19 pandemic has caused an economic recession and eroded oil demand growth in many countries across the globe, with unforeseen negative impacts on transportation fuel. Announced lockdowns in many countries around the world – particularly in the US, Europe, India and the Middle East are causing reduced air travel activities, in addition to lower distances travelled, thereby negatively affecting gasoline and jet fuel demand growth in 2Q20 and for 2020 as a whole.

Industrial fuels are also forecast to face pressure in response to reduced manufacturing activity compared with last year, negatively affecting diesel and residual fuel demand. Petrochemical feedstock is projected to decline YoY, driven by slower end-user requirements for plastics.

By the end of March, global road transport activity was almost 50% below the 2019 average and aviation 60% below. In 2020, world oil demand growth is adjusted lower by 2.23 mb/d and is now forecast to drop by 9.07 mb/d.

However, the worst contraction in major oil demand centres around the world is expected to take place in the 2Q20, mostly in OECD Americas and Europe, with transportation and industrial fuels affected the most.

As such, OPEC reports suggest that OECD oil demand is now revised lower by 1.20 mb/d while non-OECD oil demand growth was adjusted down by 1.03 mb/d, for total oil demand to reach 90.59 mb/d. Indeed, demand contraction in 2020 can be mitigated with sooner than expected easing of government COVID-19 related measures, and faster response of economic growth to the implemented extraordinary stimulus packages.

Asian refining margins for jet fuel turned positive for the first time in a month and European margins rose to the highest level in three weeks, bolstered by deep supply cuts and an uptick in flights in regional markets. Oil demand in China is reportedly at pre-virus demand levels, and Europe and the US are seeing sharp increases in oil demand, leading to higher exports from China but the realities of sluggish demand growth and limited storage capacity will hit China too.

The country’s crude storage space is running close to 80% utilization rates while clean product storage is also nearing tank tops. China’s refiners will export products, even to a depressed global market. But that strategy also has its limits and without a substantial uptick in domestic demand which seems unlikely refinery runs and crude buying will have to slow. China’s oil demand is thought to have rebounded to about 13 mb/d, just shy of the 13.4 mb/d level seen before the initial lockdown. Meanwhile, China’s air quality is now worse than it was before the pandemic.

Transportation fuels continued to suffer for the second consecutive month, with gasoline and jet fuel declining sharply YoY. Gasoline plummeted by slightly more than 0.80 mb/d YoY, while jet/kerosene declined by around 0.30 mb/d YoY. Passenger highway traffic was down by a massive 73% YoY this quarter after dropping by 88% YoY. Passenger car sales saw large declines in 1Q20, with March data indicating a drop of more than 50% YoY.

Chinese oil demand grew by 0.47 mb/d in 2019 and is projected to decrease by 0.95 mb/d in 2020. Yet, The rebound in China’s crude oil processing in April looms large over Asia’s refineries, which are already battling weak profit margins from the slump in fuel demand caused by lockdowns aimed at containing the coronavirus pandemic.

The collapse in fuel demand initially hit jet fuel and gasoline the hardest, while diesel refining margins, or cracks, held well due to ongoing industrial activity. Yet, with diesel accounting for around 50% of global refinery output, plants must now prepare to shut down crude distillation units.

Total implied US petrol demand is back above 7m b/d, up from about 5m b/d at the beginning of April. India, the oil industry’s great hope for demand growth in the next few years, is still showing an almost 50% drop in sales from the state oil refiners that dominate the retail market in the country, but that is a recovery from the 60% drop in April.

Demand is reaching 60% to 70% of normal, but it will take some time to get to pre-Covid sales and over a period of two to three months, we should get back to 80% of normal sales. Beyond that, it will be slow. The country consumed about 4.6 million barrels a day in May last year, which means demand probably stands at about 2.8 million barrels a day now. Gasoline demand is still about 47% below the same time last year, while diesel consumption is about 35% lower. Jet fuel was still a massive 85% weaker.

Trucking, which accounts for the majority of diesel consumption in India, are still facing logistical and financial constraints. About 70% of the transport sector remains frozen. Indian oil products demand will remain weak over the next few months and Road transport is expected to remain lower YoY until at least the fourth quarter.

Jet fuel demand will be a laggard, unlikely to return to pre-virus levels until 2021 at the earliest. Refiners in India, the third-largest oil importer, requested higher volumes for April from Saudi Aramco and UAE’s Abu Dhabi National Oil Co, which both increased output while cutting prices last month. India’s oil imports in April totalled 4.63 Mbpd, up 5% from March but down 4.1% from April 2019.

Indian refiners had to curtail crude processing last month as demand slumped to its lowest levels since 2007 due to a nation-wide lockdown to prevent spread of coronavirus. Lower demand and storage constraints forced some refiners to declare force majeure on oil purchases from the Middle East, defer cargoes and keep some oil in floating storage. State refiners also sold cargoes to the federal government for strategic reserve stockpiles and to avoid paying demurrage cost.

While it’s a slow process in India, there are some signs of recovery. Sales of diesel, mainly used in transport and industries and accounting for 40% of India’s total oil demand, jumped 75% in the first half of May compared with the same period in April. U.S. oil demand has surely plunged from COVID-19. Especially for gasoline, which accounts for nearly half of our oil usage, stay-at-home orders have slashed consumption to multi-decade lows. April gasoline demand averaged just 5.33 million b/d, down from 9.47 million b/d for April 2019.

As the country reopens, however, gasoline demand for the week ending May 8 was 7.4 million b/d – still lower but rising fast. Motorists were already returning to the roads, with weekly demand for gasoline rebounding by 22% over a four-week period in April, according to the gasoline price tracker GasBuddy, though purchases at the pump are still well below 2019 levels.

Meanwhile, Oil product stockpiles at Fujairah on the UAE’s east coast have surpassed 30 million barrels as demand has been down, the markets have been in contango and the Middle East finished most scheduled refinery maintenance in the first quarter, for the first time, with inventories of both middle distillates such as jet fuel and heavy distillates such as marine fuel hitting all-time highs.

Diesel consumption may suffer relative to petrol during the recovery because of its closer links to industrial growth, from trucks to cargo ships. A contango market structure is still enticing traders to seek storage options with the intention of reselling cargoes at a higher price later.

A record volume of diesel is set to reach Europe from the East in May after lockdown measures due to coronavirus left refiners in Asia and the Middle East with huge excess volumes of fuel. Refineries around the world have cut output in recent months in response to the unprecedented drop in demand due to movement restrictions imposed by governments to limit the spread of the coronavirus epidemic. But that may prove insufficient after countries including India extended lockdown measures and others, including many European countries, recover activity at a slow pace. The weak demand led to a rise in global diesel stocks and has put heavy pressure on profit margins for converting crude oil into diesel which last week hit an 11-year low below $ 5 a barrel.

At the end, all these signs pointing to a rebound are a sweet relief for the oil industry. But it is tempered by the fear that demand will still take some time to get back to pre-crisis levels as the risk of a second wave of infections and lockdowns remained very real. Demand remains the key factor for oil prices, and demand will likely remain depressed throughout the year.

In mid-April, Currie noted, it fell by about 30 million from pre-crisis levels. Now, demand is about 19 million bpd below pre-crisis levels. While
this demand has started to improve, it would still be down by 17 million bpd from pre-crisis demand this month and by 12 million barrels in June and July. By August, things will be looking up, with demand at 5-6 million bpd below pre-crisis levels. However, despite the improvement, the stock build will still overwhelm remaining global storage, which will fill in weeks.

With the price of oil up, some — but not all — hurt producers see a light at
the end of the tunnel.

Supply

Global supply is expected to fall in May to 92.8 million bpd, from 98.3 million bpd in April, and further decline to 91.1 million bpd in June. June will see the lowest supply level this year unless further production cuts are announced, with output rebounding from July. For 2020, non-OPEC oil supply is revised down further by almost 2.0 mb/d from the previous projection, and is now forecast to decline by 3.5 mb/d.

The main revisions of the month are based on production shut-ins or curtailment plans announced by oil companies including majors – particularly in North America. The 2020 oil supply growth forecast for the US is revised down by 1.3 mb/d to now show a decline of 1.4 mb/d YoY. Other large downward revisions are undertaken for Canada and Brazil by 0.3 mb/d and 0.1 mb/d, respectively. Oil supply in 2020 is forecast to show growth only in Norway, Brazil, Guyana and Australia.

For this quarter, OPEC crude oil production decreased by 3.6% this quarter, to 28.27Mbpd compared to 29.34Mbpd.Forecast shows almost 12 million b/d of total liquids output will be cut or shut in during the second quarter of this year, including roughly 11 million b/d of crude production with many of these cuts continuing even as demand recovers. This kind of large supply-side response was needed to counter the precipitous dive in demand, which was down 21 million b/d YoY in April and also down some 18 million b/d YoY in May.

Demand is expected to rebound in June, creating a near-balanced market due to the additional cuts, with demand exceeding supply by 1.8 million b/d in July. However, despite the improvement, stock build will still overwhelm remaining global storage, which will fill in weeks.

OPEC+

Massive supply cuts go even further in explaining the recent jump in prices. Oil traders view the implementation of the OPEC+ cuts favourably, with the 9.7 mb/d cuts phasing in swiftly. Part of the reason is that some oil producers, including Saudi Arabia, began having difficulty finding a home for its oil, so a portion of the cuts arguably became involuntary.

Saudi Arabia announced a surprise cut move to slash oil output to the lowest levels in 18 years this quarter as it tries to spur the recovery from energy crisis. Saudi Arabia aims to pump under 7.5Mbpd, down from 11Mbpd in April and an over compliance compared to 8.5Mbpd promised under the deal.

State-producer Saudi Aramco will cut June exports to at least a dozen Asian customers. Shipments to the U.S. and Europe will be pared even more sharply. Gulf allies Kuwait, the United Arab Emirates and Oman have taken similar steps.

While it’s typical for the Gulf bloc to be fully compliant, they’ve surpassed those standards this time by volunteering to make even deeper cuts before the first month of the latest agreement has elapsed.

Saudi Arabia’s voluntary move also places it in a stronger position for any negotiations at upcoming OPEC-plus meeting in June. Forecast shows that there could be a move to extend the current 9.7 million b/d cuts until the end of 2020 to ensure an effective drawdown of stocks.

Reports are that the Saudi Sovereign wealth fund bought a significant stake of Boeing. It seems like they are betting on a rebound as well. The more bullish sentiment, however, raises another question—will producers be tempted by rising crude oil prices to disregard quotas within OPEC+? Will U.S. shale resume drilling activity sooner than the market needs it?

What’s surprised physical crude traders even more is the commitment shown by Russia

Russian oil producers are confronting their greatest challenge in decades as they try to fend off a historic price slump without permanently damaging their fields and leading oil and gas companies are suffering amidst the market depression brought about by the COVID as most of the companies have been directly exposed to the risks of the coronavirus pandemic – be it Rosneftor LUKOIL.

Russia’s previous cuts under the OPEC+ deal amounted to about 3% of total output. Now the country must reduce its crude output by 2.5 million barrels day in May and June, down from about 11 Mbpd.Oilproductions in Russia is forecast to decline by 1.30 mb/d YoY to average 10.14 mb/d.

Iraq, which regularly flouts its pledges to OPEC+, has trimmed exports only marginally. Shipments are down only 190,000 Bpd marginally while the accord calls for the country to cut production by just over 1 million a day. Iraq’s state oil-marketing department has reduced contractual supplies of Basrah crude due to be shipped to at least three customers in June.

Kazakhstan, which like Iraq has disregarded limits agreed with OPEC+ in the past, is also dragging its feet. Tengizchevroil, the venture led by Chevron Corp. that pumps a third of the nation’s oil, was still reviewing the government’s instruction to cut back as of May 11.

Global oil supply is set to fall by a spectacular 12 mb/d in May to a nine-year low of 88 mb/d, as the OPEC+ agreement takes effect and production declines elsewhere. For some OPEC countries, e.g. Saudi Arabia, Kuwait and the UAE, lower May production is from record highs in April. Saudi oil exports reportedly have fallen to 8.19 Mbpd. Kuwait and Saudi Arabia have
also agreed to halt production from their joint Khafji oil field. This comes as OPEC’s second-biggest producer Iraq said it plans to halt output from Al-Ahdab oilfield due to protests that are hampering operations.

For June, Saudi Arabia on Monday announced that it will reinforce the agreement by voluntarily cutting production by 1 mb/d more than required. The UAE and Kuwait have followed suit with extra cuts of their own. This means that Saudi production in June will be an extraordinary 4.4 mb/d below April’s record level.

Shale

Just when everyone was getting prepared for oil to go back to zero, the other shale drops. Shale production saw a drawdown of 2Mbpd, organically on account of lower prices. US crude oil production in 2020 is now forecast to decline by 1.13 mb/d YoY to average 11.10 mb/d. Production in the seven most active shale basins will fall to 7.822 million bpd, the EIA said, down from 8.019 million bpd this month. That 87,000 barrel drop is a record monthly loss.

The U.S. government has little power to force private companies within its borders to turn off the spigot, but they, too, cut are cutting back production. American operators have already announced they are shutting off wells that have would have produced at least 1.2 million barrels per day through in
May and June.

The next worry is whether, as prices rise, discipline will endure in cash-strapped OPEC+ states and whether producers in countries like the US, Canada, Brazil and Colombia will continue to shut in supply.

Brazil quickly reversed its 200,000 b/d of curtailments last month on strong buying interest from China and it is no longer planning any shut-ins this year. Oil rig count has fallen 62% QoQ by more than half in less than two months – a much faster decline than what was seen in the last market
downturn. Although some shut-in production from old stripper wells will be lost forever, many independent producers are already working to restart
output now that physical crude prices have moved toward $ 30.

For U.S. producers, curtailments have nothing to do with shared responsibility the economics are unfavorable, storage availability is still scarce, and demand is still low. The U.S. shale patch has announced more than 1.5 million bpd in cuts for Q2, lifting the oil prices and market sentiment over the past two weeks. But with prices rising, some producers could be tempted to resume activity, nipping a sustained market recovery in the bud.US independents are targeting whatever pockets of demand resurface.

Most independent producers desperately need cash coming in to keep
their head above water and meet the terms of lending agreements. Although sub-$ 40 prices still challenge their long-term survival, current levels at least cover their operating costs. Canadian production may also need to see prices in the $ 40s before experiencing a significant return of shut-in production. The enthusiasm for cutting production shown by U.S.
shale companies or OPEC+ could weaken.

Some shale oil wells begin to break even around $ 25. Already two Texas-based shale oil producers, Diamondback Energy Inc. and Parsley Energy Inc, reported they needed oil around $ 30 a barrel to consider bringing back production and starting new wells.

Balance of Supply and Demand

Demand for OPEC crude in 2019 stood at 29.8 mb/d, 1.2 mb/d lower than the 2018 level. For 2020, and following the recent agreement, demand for OPEC crude is expected at 24.3 mb/d, which is 5.6 mb/d lower than the 2019 level. However, additional reductions recently announced by several OPEC member countries, above and beyond their voluntary commitments are expected to expedite market re-balancing, and improve the demand for OPEC crude in H2 2020.

Commercial Stock Movements

OECD commercial oil stocks rose by 96 mb this quarter to stand at 3,002 mb. This was 125.8 mb higher than the same time one year ago and 88.6 mb above the latest five-year average. Within components, crude stocks surged by 49.1 mb, while product stocks rose by 8.6 mb, m-o-m. Preliminary data for April showed that US total commercial oil stocks surged by 70 mb Q2 2020 to stand at 1,608 mb. This was 136.1 mb, or 10.8%, above the same period a year ago, and 123.7 mb, or 9.7%, higher than the latest five-year average.

Storage

The negative price crash is most clearly linked to the shortage in global storage. Currently, global storage for crude is about 90% full and for crude oil products, that figure is closer to 80%. There is 400 million bbl of available global crude storage left, and that crude stocks will build by 13.6 million bpd on average in the month of May. While this may seem like a drastic improvement from April, the oil market is not magically fixed.

The storage issue still looms large and will spill over onto trading floors, as
buyers are left with crude they cannot physically place, and into the boardrooms of oil companies which must make very costly but necessary decisions to scale back production and give the market some breathing space. Market will be forced to tighten the stock build gap during May when countries run out of local storage. After local storage is exhausted, tankers will be packed with oil barrels seeking refuge in the country with the most remaining storage capacity – the US.

A big question is whether U.S. shale producers could spoil the party by restarting shut-in production or completing wells the moment that prices rise high to earn any positive cash flow. There’s a double risk on the horizon: Just as lifting lockdowns too soon could bring a second spike in virus infections and deaths, loosening the hard-fought restraint in oil production too soon risks a second oil-price collapse

Outlook

Crude oil experienced a bunch of rallies, a bunch of sell-offs in the 18 months after the initial oil-price slump, but the oil market optimism may be running a little too far and despite all the euphoria, however, the caution is still advisable: it will probably take some years before demand
recovers to its pre-crisis level. There’s a strong recovery right now, but markets have unemployment numbers around the world and you have
income shocks, those are pretty powerful opposing forces.

Demand is expected to rebound in July, creating a near-balanced market due to the additional cuts, with demand exceeding supply by 1.8 million b/d in August. The recent price run-up reflects the anticipation of this improved market balance. The oil market is frantically trying to gauge if the world’s major demand centres are replicating the recovery in Chinese consumption, which has helped power a remarkable rebound in crude prices after the catastrophic drop below zero last month.

The lockdowns are lifting, but there is nothing to suggest that the end of the pandemic is near, or that oil supply will remain shut in. There is significant downside risk related to two events, the resurgence in COVID-19 outbreaks, and deteriorating compliance to OPEC+ cuts as demand comes back. Concerns about storage and running out of places to store crude and product have evaporated and near-month prices in the physical market are factoring this in as well as for the outlook ahead. The reopening of any number of battered economies across Asia, Europe and the Americas will be difficult, and could be set back at any moment by a second wave of Covid-19 infections. While traders are probably correct to start pricing in a longer-term recovery, it is going to be a stuttering, uneven move back towards normality. While we may see some setbacks along the way, don’t fight the Fed and don’t fight the Trump Administration that is openly rooting for higher oil prices.

OPEC+ producers will meet on 10 June to discuss the state of the market and the progress of the output agreement. So, oil production is reacting in a big way to market forces and economic activity is beginning a gradual-but-fragile recovery. However, major uncertainties remain. The biggest is whether governments can ease the lockdown measures without sparking a
resurgence of Covid-19 outbreaks. Another is whether a high level of compliance with the OPEC+ agreement will be achieved and maintained by all the major parties.

These are big questions – and the answers we get in the coming weeks will have major consequences for the oil market. For now, WTI will remain on positive trend with prices comfortably staying in levels of $ 40-$ 45 for the coming months. The appearance of tangible cuts and perception of more pronounced ones to follow have removed intense pressure on a market that
was confronting a glut in April.

Trends currently suggest prices are unlikely to drop below $ 20 per barrel, let alone hit a negative patch akin to April in the absence of a second wave of the coronavirus or Covid-19 pandemic – initial cause of the oil price crash –
resurfacing.

(The author is Vice President, Commodity & Currency Research, Motilal Oswal)

Disclaimer: The views and investment tips expressed by investment experts on moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.

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