After plunging into negative territory in April, crude oil prices have rebounded, firming up at about $40 per barrel as the second quarter draws to a close.
A growing number of analysts argue that the worst is over for oil.
A growing number of analysts argue that the worst is over for oil, with the downturn having bottomed out in April and May. Price forecasts vary, but there is a broad sense that the outlook for crude prices is constructive, even as the global pandemic shows no signs of going away.
Oil looking up
A combination of painful supply cuts – both voluntary and involuntary – along with a rebound in demand has pushed the market back to balance, albeit with both supply and demand levels smaller than before the downturn. “The situation on the oil market has stabilised,” Commerzbank analysts wrote in a note on Monday. “The Brent forward curve is even in backwardation for the first time since early March,” the bank added, referring to a situation in which near-term oil price contracts trade at a premium to longer-dated futures, which typically reflects market tightness.
WTI closed at over $40 per barrel on June 22 for the first time since March, and the market narrative continues to focus on the slow but steady process of tightening. “While the oil market remains fragile, the recent modest recovery in prices suggests that the first half of 2020 is ending on a more optimistic note,” the International Energy Agency wrote in its June Oil Market Report. “New data show that demand destruction in the early part of the year was slightly less than expected, although still unprecedented.”
Looking out a bit further, the IEA noted that the market will continue to tighten in the second half of 2020 and into 2021. For instance, global supply will fall by 7.2 million barrels per day (Mbd) this year, and demand will fall by 8.1 Mbd, but next year the agency sees demand rebounding by 5.7 Mbd while supply only rises by 1.8 Mbd. In other words, a substantial deficit could drive prices higher.
The inventory overhang on the order of a billion barrels will take years to work off.
The inventory overhang on the order of a billion barrels will take years to work off, and the 9.7 Mbd of OPEC+ cuts ensures enormous spare capacity for the indefinite future. Taken together, there is little chance of a dramatic run up in prices even if the market is technically exhibiting a supply-demand deficit. But the renewed sense of price optimism from many analysts is notable, even as $40 was once considered catastrophically low, and still is for many oil companies.
“Oil prices have already reached an interim stage of recovery. The 40-dollar mark is the level around where they will fluctuate for a while but huge deviations are not likely,” Rystad Energy said in a commentary.
Goldman Sachs says WTI oil could average $51 per barrel next year, and Bank of America Merrill Lynch puts their estimate at $47. Other analysts have forecasts that run the gamut, but tend to follow the same logic – demand will rebound steadily, tightening up the market, paving the way for modest price gains.
Not out of the woods
But there are also downside risks that could wreck these forecasts, even if they remain outside of base case scenarios. For instance, the global pandemic is still raging, and in fact, the spread of infections is accelerating in some parts of the world, including many U.S. states and more than a few countries in Latin America.
The fundamentals may be tightening, but demand remains substantially lower.
Gasoline demand has bounced back, but not to 100 percent. Jet fuel demand is likely to be impaired for years. The IEA does not see oil returning to pre-pandemic levels until at least 2022. The fundamentals may be tightening, but demand remains substantially lower.
That inevitably turns the analysis back to why the market has tightened up at all. An incomplete rebound in demand only explains part of the stabilization. Instead, the bulk of the rebalancing is happening on the supply side. Put bluntly, OPEC+ is doing the lion’s share of the work by keeping 9.7 Mbd off of the market.
The risk, then, is the potential breakdown in cohesion on the part of the OPEC+ coalition. The group need not return to a full-on price war to disrupt the market. Many forecasts for higher oil prices tend to bake in the assumption that OPEC+ sticks very closely to the existing framework. For instance, the IEA’s tepid supply growth figures for 2021, which underpins its constructive outlook on oil prices, is based on the assumption of 100 percent compliance of the OPEC+ cuts.
The problem is that OPEC+ hasn’t even hit 100 percent compliance to date. In fact, OPEC+ only complied with roughly 87 percent of the cuts in May, according to an analysis from Standard Chartered, largely due to the lagging efforts on the part of Iraq, Nigeria and Angola. More powerful members of the OPEC+ coalition have pressured Baghdad into stronger compliance. Iraq has promised not only to beef up compliance, but also to make up for past overproduction by making deeper cuts.
It remains to be seen how this dynamic plays out, but the internal politicking of OPEC+ could have outsized influence on the broader oil market if tensions flare up. The group recently extended their production cuts for one month, through the end of July. But the very short duration of the extension points to the tricky task of maintaining compliance and cohesion. “We consider Iraq’s oil policy to be a key factor for oil prices in Q3 and Q4; without a dramatic trimming of its 605kb/d overproduction, we think it will be difficult for OPEC+ to continue in its current form,” Standard Chartered warned in a report on June 18.
To be sure, OPEC+ has little interest in letting prices crash again. But that does not mean that they will all agree to stick to the agreed upon trajectory for the next year or two.
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