Crude oil slumps as planned cuts still behind demand shock

President Trump in a tweet was quick to take credit for the production cuts which the US is only going to support through involuntary reductions. Especially from troubled shale oil producers, many of which are currently selling at prices below cost. He also stated in another tweet that the total production cut was more likely to be closer to 20 million barrels/day. Such a number would only be achieved through 100% compliance from the OPEC+ group, governments filling their strategic reserves and through force production cuts, especially in the U.S.

Having done what is currently possible to support the oil market the focus will now turn to the U.S. for signs of an accelerated production slowdown. Most importantly however is when lock downs across the world begin to be lifted. Only a pickup in demand can at this stage save the oil market from further stress. The longer the reopening takes the bigger the risk of storage facilities running out capacity. If that occurs prices could suffer a significant sell-off to force shut ins by the weakest producers.

The very painful production cuts announced was in other words primarily agreed in order to slow the sharp inventory build expected in coming months. By cutting now oil producers have attempted to ‘flatten the curve’ while waiting for demand to recover.

Many investors and traders, some perhaps not use to trade crude oil have entered into long positions in recent weeks. These decisions have undoubtedly been taken on the assumption that oil looks very cheap historically and that the pandemics grip on our daily lives and habits will eventually ease.

Once again, however, as we highlighted in a recent update we have to warn about the dreaded contango. Our readers have probably heard stories about oil traders once again making a lot of money from buying crude oil in the spot market, store it for a few months, and then sell it back into the market at a higher price. This so-called contango structure is reflecting an oversupplied market where lack of demand has left the spot price the cheapest on the curve.

At the same time the expected fallout in terms of production being removed may pave the way for another oil shock to the upside in a few years’ time. These opposing ideas are currently keeping the forward curve very steep. And while those who have access to storing unwanted oil for future delivery can make a lot of money, an investor buying crude oil, whether it is a future, CFD or an ETF will all be facing the opposite challenge.

Using WTI crude oil as an example. The soon to expire May contract (CLK0 or OILUSMAY20) is currently trading 34% below the June, 52% below July and 61% below the August contract. In order to make any return on a long crude oil position, these are the hurdles a buyer will face. Alternative a trader could consider buying further out, ex. the December contract. By then however the price needs to be 71% higher for the trade to work out. The penalty for going long Brent, the global benchmark, is somewhat lower given the described cuts which will primarily impact Brent.

With production cuts now priced into the market the risk of disappointment remains elevated with the only reliable cure being a recovery in demand. Despite promising signs of improved conditions in Europe, other regions are however only beginning to feel the full impact of the invisible enemy.

Major commodity performances since January 17 when the covid19 became known outside of China. The energy sector has suffered steep losses as global demand for fuel has seen a historic collapse.