The past weeks witnessed a new price war between OPEC (Saudi Arabia) and non-OPEC (Russia), the biggest slump in oil demand in history due to the coronavirus measures and negative oil prices in the US owing to storage capacity shortages. Whilst demand for oil will not fully recover, this need not hold back the oil price. A recovery will depend on three different factors.
Chain of events sparks ‘Perfect Storm’
These are exceptional times for the oil market. The oil price has displayed a more erratic and volatile pattern than ever. Early in the year Brent oil still fetched well above USD 70 per barrel. The measures to contain the coronavirus in China dampened demand for oil, creating some initial downward price pressure in January and February. But the price fall really gathered pace on 6 March when OPEC and its partners failed to agree on fresh production restrictions. Adding fuel to the flames, full or partial lockdowns were imposed shortly afterwards in the second half of March throughout Europe and the US. A ‘Perfect Storm’ was born and demand for oil went into free-fall.
Preventing physical delivery comes at a cost
Normally, the supply of oil is adjusted to demand. But this cannot be done with the bizarre speed with which demand collapsed. Inventories spiralled as a result. The squeeze on storage capacity became all too clear on 20 April – the day that the price of West Texas Intermediate (WTI) plunged to USD -40 per barrel. Yes, you read correctly: minus 40 dollars per barrel. One day before the expiration date for oil contracts for physical delivery in the month of May, a number of position traders holding contracts did not want the oil to be physically delivered. Normally that is not a problem, as you simply sell the contract to a party who does want physical delivery. But due to the shortage of storage capacity, none of these parties were interested and panic broke out. Hedge funds and Exchange Traded Funds (ETFs) will no doubt have learned their lesson now. In future, they will reposition in time to contracts with delivery further in the future in order to prevent actual delivery. Even so, a fresh wave of panic, leading to negative prices, can no longer be fully ruled out.
Demand will take years to recover
The measures to contain the spread of coronavirus have severely depressed demand for oil. Now that the lockdowns are being gradually eased, the economy can start to pick up steam again. And demand for oil will follow in its slipstream. That said, I think that part of the former demand has been lost forever, particularly in Europe. Commuting will decrease now that working from home has proven to be a viable solution for many jobs, and most offices are not suitable for social distancing. Similarly, the recent success of webinars and online conferencing will bring the need for business flights under scrutiny. Future growth in demand for oil will mainly come from Asia and Africa. This was already the case, but the impact on total demand may now be less if demand in Europe remains lower.
But a price recovery is probable
Financial markets are opportunistic. As soon as hope of better times beckons, market parties will seek to profit from fresh opportunities. Recently, the oil price has already found tentative support in the prospect of a pick-up in demand, the OPEC production restrictions and the rapid decline in US production. The expectation that the market will return to equilibrium is sufficient to prompt a cautious price recovery. At a certain point, when a new balance is found between lower demand and supply, a higher oil price will be justified. The oil that is produced also has a cost price which, in time, will be the minimum price. Taking into account the necessary investments in the future, I foresee a price recovery to USD 40-50 per barrel towards the end of 2020 and in 2021. However, in view of the enormous and ongoing accumulation of inventories, it won’t get much higher any time soon.
A price recovery will depend strongly on three crucial factors: 1) there must be no new lockdowns, 2) OPEC and its partners must comply with their commitments, and 3) the market must be confident that a new supply-demand balance will be found. Any disappointment or setback that could impact on the demand for or supply of oil will trigger strong price movements. Unfortunately, therefore, we cannot entirely rule out a recurrence of negative prices on the trading screens. Against this uncertain backdrop, investors should remain prudent and weigh up the tempting prospect of a price recovery versus the risk of a renewed sharp price fall. What appeared to be a simple game of supply and demand in the oil market has proved to be a lot more complicated. This has already wrong-footed many investors. Geopolitics and government interventions have clearly become important factors that can unexpectedly interfere with the ‘normal’ run of the game.
This column has been published earlier on Beleggers Belangen.