INDUSTRY INSIGHT

In the foothills of a bullish cycle in crude oil

By David Hanna, Argus VP of Business Development, North Asia

It has become a truism to declare that the COVID-19 outbreak has caused the greatest demand destruction in modern history. The impact has been deep, broad, and swift. As major economies seized up, and travel and discretionary spending came to a near halt, demand for energy and commodities plummeted.

This trend showed up most clearly in the king of commodities, crude oil. Even the 6mn b/d of lost demand from the Opec embargo against the US in the late 1970s falls short of the damage to oil demand we have seen in 2020. Unlike the previous two episodes of global oil demand destruction during the financial crises of 2008 and 1999 — which were the result of internal factors in the economy percolating to the surface — this time the cause of the demand collapse was entirely external. This accounts for the deep and widespread destruction to the global economy that we are still reeling from. But the good news is that, at least in principle, once the virus is contained and the pandemic subsides, the underlying market fundamentals, which were generally strong before the outbreak, should return to the surface and lead to an initially strong recovery.

“Once the virus is contained and the pandemic subsides, the underlying market fundamentals, which were generally strong before the outbreak, should return to the surface and lead to an initially strong recovery.”

“Saudi Arabia reversed course in May and has successfully rallied other Opec members and even Russia to join it in implementing what has become the largest collective output reduction in Opec’s history.”

In fact, we are already seeing the start of a recovery in oil prices even before the pandemic peaks out. After an abortive attempt by Saudi Arabia in March and April to return to its 2014 strategy of tolerating low prices to defend market share – which was prompted by Russia’s intransigence during talks with Opec about output cuts – the country reversed course in May and has successfully rallied other Opec members and even Russia to join it in implementing what has become the largest collective output reduction in Opec’s history. At the same time, independent US producers have also carried out the largest output cuts in recent memory, although this has been in response to market forces. As a result, US crude output has fallen from a peak of about 13mn b/d in March to just above 11mn b/d currently.

Opec’s compliance level has surprised the market. This, combined with a nascent although spotty recovery in consumption as self-imposed lockdowns are relaxed in many locations, has bolstered prices. After sinking to a 20-year low in April, US benchmark crude WTI has since rallied fairly steadily to about $40/bl.

The start of a recovery, or just a reprieve?

This begs the question, are we at the start of a fully fledged recovery in oil prices, or is this just a temporary blip? Pessimists rightfully point to the likelihood that, while things are starting to slowly get back on track in most economies, the engine of global growth is not firing on all cylinders. China, the world’s second-largest economy, appears to be enjoying a V-shape recovery, but the world’s largest economy, the US, is being battered by a second wave of infections that appears to be accelerating at the time of writing. Other large economies are also showing mixed signs, with Japan and South Korea doing relatively well while some European economies are wobbly.

The latest forecast from the IMF suggests that the global economy will be back on track next year, but that does not mean it will be back to “normal,” whatever that means in the post-coronavirus world. Even after the virus abates and the economy gets back on its feet, things will probably not return completely to the status quo before the pandemic. In fact, we have already entered a “new normal”, marked by restrained discretionary spending on the individual level and more cautious investment at the corporate level. Moreover, changing demographics point to a reinforcement of this trend, as members of Generation Z, those in their 20s who had just started entering the workforce right when the coronavirus hit, were already high savers and low spenders compared with their parents and grandparents in the Baby Boomer generation. As they enter their 30s and hit their prime working years, they are likely to maintain their frugality.

“We have already entered a “new normal”, marked by restrained discretionary spending on the individual level and more cautious investment at the corporate level.”

“There is also the long-term scarring on the economy to consider, which some economists estimate could take as long as a decade to fix. There may also be some permanent damage, as many of the lost jobs – as much as one-third, according to some estimates – will not be returning.”

In addition, it is likely to become common practice for companies to allow employees to continue to work from home for part of the week and to do a mix of video conferencing and face-to-face meetings, now that this has proven to be viable and even beneficial. This will mean less demand for gasoline in the US but will probably create a net increase in electricity demand as residential usage goes up, supporting LNG demand at the expense of crude.

And don’t forget the drag on the global economy from the ongoing US-China trade war, which in fact has very little to do with trade. The trade war was always about deeper issues such as high-tech supremacy, but in recent months it has morphed into an outright ideological war between democracy and centralised government, or more properly, between corporate capitalism and state-backed capitalism. Even if President Donald Trump is unseated in the upcoming presidential election in November, his successor, regardless of his or her political leanings, will almost certainly maintain a tough line on China. In fact, recent press reports in China’s state media suggest that the government there is more concerned about Trump losing the election, as his detractors may be eager to use China-bashing as a political tool to garner domestic support.

There is also the long-term scarring on the economy to consider, which some economists estimate could take as long as a decade to fix. There may also be some permanent damage, as many of the lost jobs – as much as one-third, according to some estimates – will not be returning.

But despite all of this, we believe that the current rally is likely to continue next year and beyond, albeit at a relatively slow pace. We say this for several reasons.

We’ve already hit bottom

When talking about the price of oil, most market observers have been focused squarely on the demand side of the picture. After all, the coronavirus has wreaked the greatest damage on demand in memory, driving down the prices of transportation fuels and crude to historic lows. In this context, it is easy to lose sight of the fact that output too has seen the biggest reductions on record. While US shale oil producers stubbornly refused to embrace output quotas like Opec for fear of being labelled a cartel, they have been forced to slash output as the industry goes through a process of weeding out the weaker players.

“Where Opec failed in 2014 to rein in US output – with its policy of protecting market share by letting prices fall – the coronavirus has succeeded,” says Argus’ Head of Forecasting Francis Osborne. Overall US oil production has dropped from a peak of 13mn b/d at the start of this year to 11mn b/d, and Osborne predicts that output will not return to pre-coronavirus levels for a year or more, as the larger, more efficient companies focus more on profits than cash flow, and banks become more selective in offering lines of credit.

“While US shale oil producers stubbornly refused to embrace output quotas like Opec for fear of being labelled a cartel, they have been forced to slash output as the industry goes through a process of weeding out the weaker players.”

“Most industry estimates place peak oil demand somewhere between 2025 and 2030, and it is unlikely that the peak will be moved significantly far forward.”

Moreover, contrary to some highly publicized claims that peak demand for oil has already arrived because of the virus, we see further room for continued growth in demand at least to 2022 and probably far beyond. Most industry estimates place peak oil demand somewhere between 2025 and 2030, and it is unlikely that the peak will be moved significantly far forward.

Another factor that will aid the demand recovery is the same factor that exacerbated the fall in the first place — the multiplier effect. As discretionary spending gradually resumes, for every one dollar that a US citizen spends on a coffee or every one yuan that a Chinese shopper spends at the mall, the benefit to their economies is magnified about threefold — based on current discretionary spending ratios — as part of the money spent on consumable items is spent again by shop employees on other things. As a result, once spending starts to return, we should see a rapid acceleration.

Based on the above, Osborne expects global demand for crude to recover to 96.87mn b/d next year, a 14pc jump from 85.05mn b/d in the second quarter of this year. Moreover, demand should continue to recover, although at a slower pace into 2022, reaching 98.47mn b/d. This figure will bring demand close to the pre-coronavirus levels of about 100mn b/d. The result is a tick-shaped recovery pattern, which is consistent with our view for most commodities and the economy at large.

The long climb back

Meanwhile, on the supply side, despite its massive output cuts, Opec+ has not been able to keep pace with the unprecedented erosion in demand, at least for now. As a result, the world faced a peak supply glut of 6.24mn b/d in the second quarter, according to Argus Consulting. But this is likely to correct as we enter the second half of the year, with the supply overhang flipping into a shortage of over 4mn b/d for the remainder of the year.

Further out, Osborne expects that “with non-Opec supply likely to remain constrained in 2021, Opec+ will be able to relax its production regime and raise output again. But not for long. The reality is that the success that Opec+ has in rebalancing the market will be rewarded by higher prices — which will help producers everywhere boost investment again. Opec and its allies can expect to have to redouble their efforts in 2022 onwards as supply growth once again outstrips demand growth.”

What this means for global crude pricing is a sustained recovery from the current level of about $40/bl for WTI to $49/bl next year and $52.30/bl for 2022 as a whole. For liquids-based petrochemical producers in Asia and Europe, which compete with gas-based producers in the Middle East and the US, this implies a rising cost base, which may further hurt petrochemical margins. That is because, historically, downstream margins have tended to rise during a bearish crude cycle and narrow during an upswing. As a result, all things being equal, petrochemical producers may be in for tighter margins over the coming year.

Listen to GPCA’s webinar recording on the topic of ‘Middle East Petrochemicals Competitiveness in Low Crude Oil Price Environment’, featuring Chuck Venezia, Senior Vice-President, Global Petrochemicals, Argus Media, and Muhamad Fadhil, VP, Business Development, Petrochemicals, Argus Media.