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Shale is the name of the game

The SPDR S&P Oil & Gas Exploration & Production ETF (XOP index) gained 0.5% in June, the WTI oil price rose 10.7%, and the Brent price moved up 16.5%. Year-to-date, the XOP index, WTI price and Brent price are down 45.0%, 35.7% and 37.7% respectively.

WTI XOP IndexSource : Bloomberg

The oil market continues to be extremely uncertain, with widely varying assessments of the level of inventories. The June IEA report showed an increase of 242 million barrels of OECD inventory since the February low, an increase of ca. 200 million barrels of Oil on Water (in transit or floating storage), and an increase of less than 50 million barrels of non-OECD inventory. This total build of less than 500 million barrels contrasts with the IEA’s supply/demand model, which suggests that inventories should have expanded by 1.6 billion during the first half of 2020. The 1.1 billion of “missing barrels” is reconciled through the IEA’s “miscellaneous to balance” account, which hit at a record 6.3 million barrels /day (mmb/d), three times above its previous high (in 40 years of data). Needless to say, this official report plagues the world’s largest commodity market with a huge degree of uncertainty. Participants have turned to satellite services and anecdotal information to get a better grasp of reality.

The most likely scenario is that, rather than expanding by 1 or 1.5 billion, as expected just a few months ago, global inventories have grown only by 500 million barrels. In the past, when the “miscellaneous to balance” number has been high, the IEA typically later proceeded to revise historical demand upwards.  In the supply/demand/inventories equation, inventories are the most certain element (often mandatory by law) to be reported, followed by supply, which can be partially tracked through tanker movements. Demand, however, is notoriously difficult to track and the current probable understatement is unprecedented. Indeed, the discrepancy between inventories and supply/demand considerations is so large that it is difficult to fathom. If inventories are indeed only 500 million above normal, then a return to that level can be expected by the end of 2020, thanks to the OPEC cuts. Conversely, if the IEA’s supply/demand forecast is correct, then normal inventories are to be expected only by year-end 2021.  This huge difference explains why some brokers are relatively constructive on oil, while others remain pessimistic. The conclusion drawn from each premise is extremely different.

In addition to uncertainty with respect to inventory build, estimates of future demand are all over the map. Some demand forecasts for 2021 are as high as 102 mmb/d, while, on the negative side, an outlier is as low as 90 mmb/d. The IEA 2021 projection stands at 97.4 mmb/d, which is 2.4 mmb/d below the 2019 level and assumes a hit to the economy worse than during the Great Financial Crisis. The aggressive 102 mmb/d demand forecast supposes a large pick-up in driving, as people avoid mass transit and air travel due to the virus. The Apple mobility app suggests this could indeed be the case, with US driving currently up 19% – although it does have a tendency to overstate. At this point, Chinese oil demand is more or less in line with January levels, and the Indian oil minister sees his country’s demand returning to normal during the summer. US oil demand is down 15% year-on-year according to the EIA. As for the low 2021 demand forecast of 90mmb/d, it assumes a powerful second wave of Covid-19 that keeps the global economy at extremely depressed levels for the next 18 months. The most likely scenario, in our view, is a measured pick-up in oil demand as the global economy continues to reopen.

Oil supply has been falling rapidly. US oil production is now 2.1 mmb/d off its early March peak. Part of this decline is attributable to shutdowns, but the majority is driven by natural declines. With the oil rig count 73% below its March level and frac spreads down by a similar extent, US production is set to drop significantly by year end. The international rig count now stands at its 2003 level, setting the stage for major production declines across the globe. Venezuelan output, for instance, has hit a 60-year low. The virus’ total impact on production will likely amount to at least 5 mmb/d. It is difficult to gauge the exact hit to supply, with OPEC+ and non-OPEC shut-ins sometimes disguising lost productive capacity. The lack of new projects being sanctioned will take anywhere from months to years to impact the market, given that conventional oil has long lead times. OPEC+, in general, has shown surprising conformity with its agenda, Saudi Arabia and Russia proving almost perfectly compliant. Only Iraq, Nigeria and Angola have been slow to conform, but they have now promised to make up for their overproduction.  

The impact of the coronavirus on the oil market will likely be with us for years. In the near term, demand has been crushed. In the medium term, lost supply will show up in earnest during 2021 (aside from shut-ins). Demand will return gradually but, at some point, the supply impact will exceed the demand impact. At that point, the oil price will need to increase in order to encourage new spending, although the supply response will then take several years to materialise given the accumulated low level of capital expenditures. While we wait for the supply impact to cross the demand impact, OPEC plans to once again remove inventory from the market. Investor patience will be rewarded, but the slow recovery remains frustrating.

(Update : 07.2020)

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