Crude oil slumps as planned cuts still behind demand shock
Head of Commodity Strategy
Summary: Faced with a historic drop in demand, the OPEC+ group of producers met during the Easter break and agreed to implement a historic production cut. The market reaction has so far been very muted with WTI and Brent both trading lower. The slow implementation of the agreement, the risk of non-compliance and no firm commitment from others to follow suit could see the market remain under pressure until the pandemic loosen its grip to let fuel demand recover.
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OILUKJUN20 – Brent Crude Oil
OILUSMAY20 – WTI Crude Oil
XOP:arcx – Oil & Gas Exploration & Production
XLE:arcx – Energy Select Sector SPDR Fund (Large-cap US energy stocks)
The OPEC+ agreement over the Easter weekend to cut production by a historic 10% has so far received a lukewarm response from the market. Faced with a historic drop in demand, Saudi Arabia and Russia cheered by President Trump finally agreed that the OPEC+ group of producers would make voluntary production cuts of 9.7 million barrels/day. That number will drop to 7.7 million barrels/day during the second half and to 5.8 million from January 2021 to April 2022.
While the number of barrels they agreed to cut will do little to off-set the current demand drop, estimated to be somewhere between 20 and 30 million barrels/day, the length of the agreement to 2022 has supported prices at the back of the curve. This on the assumption that the price of oil on the other side of the pandemic will rally as demand recovers, storage tanks begin to drain and lack of investments in new wells will support the price.
The negative reaction seen so far is a combination of several factors. First of all the deal to cut will not be implemented until May. While Saudi Arabia and its GCC friends are likely to turn down their taps from May some of the other producers, especially the 2.5 million barrels/day drop from Russia is likely to take longer. Adding to this doubts that notorious cheaters like Iraq and Nigeria will fully implement their combined cuts of 1.5 million barrels/day.
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.