The Fuse

Oil Sinks as Demand Disappoints

by Nick Cunningham | September 11, 2020

After several months of oil prices stuck within a very narrow range, Brent fell below $40 per barrel on September 8. The selloff put an end – temporarily at least – to several months of improving oil market sentiment.

The downward correction comes as the rebound in demand has begun to sputter. Some analysts still see a tightening going forward, but there is no longer any expectation of a quick recovery.

Demand disappoints
After the epic plunge in demand in April, the oil market saw a swift rebound by June. While consumption did not rebound to pre-pandemic levels, the partial recovery combined with supply losses meant that the market had technically flipped into a deficit. Brent crude moved up to $46 per barrel by late August on the back of declining inventories and expectations of slow-but-steady increases in demand.

Heading into the fall, the mood is shifting again. Part of the recent fall in prices can be attributed to speculative moves by investors – trader sentiment recently shifted in a more negative direction. But that is a symptom of disappointing data from the market. “From a fundamental basis we see the price adjustment as overdue,” Standard Chartered wrote in a note on September 8. “Balances have not yet justified Brent prices above USD 40/bbl in our view, and forecasts of huge Q3 global supply deficits have not materialised.” The investment bank has been arguing since July that oil prices had already moved too high.

“Now that those prime driving days are behind us, we are likely to settle into a prolonged pause in the demand recovery.”

The end of summer unofficially signals an end in the peak driving season in the United States. Gasoline demand fell 375,000 barrels per day (b/d) in the last week of August and then slipped again by another 396,000 b/d in the first week of September. Gasoline demand is now at its lowest level since June. “Now that those prime driving days are behind us, we are likely to settle into a prolonged pause in the demand recovery,” Fred Rozell, president of OPIS, said in a statement.

“The plateauing in demand is a symptom of the continuing aggressiveness of the coronavirus and is telling us that it will take longer to get back to normal,” said Daniel Yergin, vice chairman, IHS Markit, said in a statement.

As of August, demand was still down more than 8 million barrels per day (Mbd) from the same month a year earlier, according to the International Energy Agency.

Inventories still remain at historically high levels.

Inventories still remain at historically high levels. Globally, oil inventories are 600 million barrels above the five-year average and they are no longer declining as fast as expected. Inventories have only declined at a pace of 2.2 Mbd since the start of the third quarter, significantly slower than the 4 Mbd that many forecasters had expected. The drawdowns slowed further in the last 30 days to just 1.6 Mbd, a pace that is “underwhelming,” Morgan Stanley said in a note on September 9.

“Short-term oil market fundamentals look soft: the demand recovery is fragile, inventories and spare capacity are high, and refining margins are low,” Morgan Stanley said. Adding some fuel to this narrative was the latest EIA data, which showed an increase in U.S. crude stocks for the first time in nearly two months.

Weak demand is also hitting the refining sector.

Meanwhile, weak demand is also hitting the refining sector, which is now globally suffering from overcapacity. Too many refineries and not enough demand leaves less competitive facilities in the lurch. Old refineries, especially in Europe, could be “destined for the scrap heap,” the Wall Street Journal reported recently. Europe’s “youngest” refinery was constructed 45 years ago.

Oil still tightens in 2021
Despite the gloomy assessment, most analysts still see prices rising in 2021, albeit modestly. Morgan Stanley sees Brent averaging $40 per barrel in the fourth quarter, but moving up to $50 per barrel next year.

Goldman Sachs made a case for a “bullish” trajectory in 2021. The bank noted that despite the most recent “second wave” of coronavirus cases this summer, the oil market was still in a supply-demand deficit. The bank sees Brent rising to $58 per barrel by the end of 2021.

However, while demand may rebound further as the global economy improves, the relatively rosy outlook from Goldman Sachs rests on a few key assumptions. The bank says that there is “rising likelihood of widely available vaccines next spring,” a scenario that is not at all assured. Second, the bank says that OPEC+ will likely maintain discipline and keep surplus oil off of the market, another risky assumption.

The one thing working in the direction of higher prices is the fact that U.S. shale is very unlikely to rebound anywhere close to pre-pandemic levels. Rig counts remain stuck at record lows. The backlog of drilled but uncompleted wells could add some additional production in the short run, but the steep decline rates endemic to shale drilling ensure steady erosion of supply. Without shale flooding the market again, there are better odds of a tighter oil market in the next year or so.

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