Paradigm shift in supply/demand could boost the crude oil price

Amid many assets are losing their value globally due to the shrinking economic activities triggered by the pandemic of COVID-19, the crude oil market has shown plunge as well. Besides pessimistic forecasts for petroleum demand, collapsing a joint production cut system that has underpinned crude oil prices also accelerates panic in the market. Meanwhile, we can see the possible formation of a new order in the crude oil market.

NYMEX WTI crude oil futures front-month contract had remained in a range bound between $50/bbl and $65/bbl since the beginning of 2019 until mid-February this year. However, pessimistic sentiment triggered a free fall to below $20/bbl after late February. There are some predictions that crude oil prices could show a further decline to below $10/bbl or about $5/bbl.

The latest monthly reports by OPEC and the International Energy Agency downgraded their forecasts for global petroleum demand in 2020 by about a million barrels per day from their previous month reports. Since they previously expected world oil demand at 100.1 million bpd, the revision is only about 1%. But IEA is still amending their forecasts and global petroleum demand could dip by 2 digits, according to their current opinion.

Despite such a significant forecast for fading demand, OPEC and its alliance partners including Russia failed to extend current agreement to cut production beyond end-March. Saudi Arabia and Russia are going to start the price war with increasing supply. Although current production curbing is cutting 2.1 million bpd from the output in October 2018, boosted production could lead the market to over-supply by up to 4 million bpd after April.

Global oil output in October 2018 when OPEC+ set baseline for the existing production curb was 102.53 million bpd, while production in February 2020 was 100.26 million bpd, according to the U.S. Energy Information Administration. Production cut by OPEC+ has been mostly offset by increasing U.S. shale oil supply. Meanwhile, decreasing supply from Iran and Venezuela that are under sanction and from Libya where civil war suspends oil output has made world petroleum balance of supply and demand equation. However, the situation will be changed drastically to historic oversupply.

Production curbing by OPEC did not comply at all for long years in the history, then the organization stopped setting the production quota in December 2015. However, disorderly massive production caused sharp price decline and new joint production curbing was resumed with involving alliance partners including Russia in January 2017. High compliance with the output cut has sustained the market afterward.

Only Saudi Arabia has kept high compliance and other major producers such as Iraq and UAE have not met curbing targets. Production in Russia, the giant among non-OPEC alliance nations has not been reduced significantly as well.

Saudi's desperate change in its production policy shocked many producers. Even the U.S. that has irresponsibly enjoyed the fruits of production curb by OPEC+ is considering participating in a new joint output cut. If the U.S. tries to make Saudi to resume output limit, it is not at all persuasive as they have increased production as much as they like, against Saudi's consistent effort. However, if the U.S. proactively joins curbing, a great shift for paradigm would be seen.

When we see the historical correlation between supply and demand balances with prices, more than 2 million bpd of excessive supply usually depressed prices by $20-$30/bbl, thus more than 3 million pbd of consistent oversupply should generate further extreme price slump.

However, we are unable to say that the current crude oil market is driven by supply and demand as prices are declining ahead of the major change of supply/demand. In the fundamental factors driven market, prices typically lag to change of supply and demand balance. Therefore, the current crude oil market is drove by speculations and the situation relatively resembles a speculative market accelerated by guess over geopolitical risks.

Since it is difficult to predict how long the COVID-19 pandemic continues with what scale, how shrinking economic activities affect the global economy is unclear as well. Thus it is natural that anxious sentiment rules the market.

However, industrial activities don't have so close correlation with petroleum consumption than many people estimate. The industrial production index in the U.S., China, and Japan over the past decade only has 0.41-0.48 correlations with crude oil throughput. For the past 5 years, it decreases to 0.2-0.3 which has almost no correlation.

Crude oil processing in China in Jan-Feb only decreased by 3.8% on year despite its industrial production index fell 13.5% from a year ago. March month to date crude oil throughput in the U.S. dipped only 1.4% on year, while petroleum products delivery increased by 0.5% on year. Although crude oil demand in Japan shows 8.3% on year decrease in the first half of March, the figure includes impact by the consumption tax hike. In February when COVID-19 didn't give so significant influence in Japanese society yet, crude oil throughput fell more than 9% on year.

In conclusion, the impact on global petroleum demand by shrinking economic activities is likely to be smaller than most expects. Meanwhile, the same as cooperation on production curbing between OPEC and non-members like Russia was generated by price tumble in 2016, current price collapse could build new output curb systems that include the U.S.

Although panic in the market may persist until the rising number of COVID-19 infected people will peak out globally, then the oversold crude oil market can surge with absorbing speculative funds boosted by ongoing monetary easing.