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Oil price: barometer for the coronavirus pandemic

For the oil market, the road out of the crisis is a long one. When will we see a sustained recovery?
Max Holzer

An article by Max Holzer

Head of Relative Return and 
member of the Union Investment Committee (UIC)

Oil is still seen as the commodity that keeps the economy’s engine running. But nothing is running smoothly this year. Oil is used both as a fuel and as a base material for industry, which is why its price serves as a barometer for the economy as a whole. And economic activity dropped dramatically when the coronavirus pandemic broke out. Although lower prices are good news for drivers and those buying heating oil, investors are continuing to hold back. This is because there will be no sustained recovery in the price of oil until a vaccine comes onto the market and demand in the economy has picked up significantly.

The renewed softening of prices in the international crude oil market reveals the fragility of the economic recovery.

Max Holzer

The oil market’s fortunes are currently heavily dependent on how the coronavirus pandemic continues to unfold and on the steps taken to contain it. The latest indications provide more grounds for caution than optimism. Recent weeks have seen a faltering of the recovery of demand, and thus the oil price, which had collapsed due to coronavirus. Oil prices have slipped back below the threshold of US$ 40 per barrel of Brent crude since the start of September, having held steady for a while. The price is unlikely to bounce back above US$ 50 per barrel until well into next year. This means that prices at the petrol pump will remain moderate in the months ahead.

What is the reason for this situation? Until August, demand had been recovering strongly following its unprecedented slump in February and March. But the Organization of the Petroleum Exporting Countries (OPEC) and other producers, such as Russia, have now slightly increased their output, having initially reduced it by 9.7 million barrels per day. The situation on the demand side is even more significant, however. Demand remains far below its pre-pandemic level.

Supply discipline by OPEC+ halts the price collapse and restores equilibrium in the oil market

IEA anticipates continuing reduction of excess supply
Supply discipline by OPEC+ halts the price collapse and restores equilibrium in the oil market
Sources: IEA, Union Investment; as at 18 September 2020

Fewer aircraft in the skies

Look up and it is noticeable that relatively few aeroplanes are flying overhead. Data from Eurocontrol, the European air navigation safety organisation, shows that the number of flights in September was down by just over half compared with the same month of 2019. After collapsing as a result of the pandemic, aviation did pick up. However, this recovery has now stopped and the number of flights is falling again slightly. This is due to rising numbers of coronavirus cases and thus new travel restrictions, which can change at very short notice. The difficulties in the aviation sector are reflected in the oil price. After all, aviation accounts for around 8 per cent of oil consumption. But demand for oil products such as petroleum remains well below previous levels in other areas too, because many people are still working from home or are postponing leisure activities and holidays.

The renewed softening of prices in the international crude oil market also reveals the fragility of the economic recovery. There is unlikely to be a sustained economic recovery until a coronavirus vaccine comes onto the market. Despite the upward momentum of recent months, Germany’s economic output is not expected to return to its pre-pandemic level until 2022.

Futures curve reflects oversupply

The oil futures curve shows the scale of the excess supply. Prices are significantly lower in the short-dated than in the long-dated segment. This means that the market is prepared to pay less for oil delivered in the coming days and weeks than for oil delivered in a few months or years. In the jargon, this phenomenon is known as ‘contango’ and means that it is worth storing oil and selling it at a later date.

The increased incentive to hoard all this oil exacerbates the problem of where to store it. Oil inventory levels shot up in April and May as a result of the sudden collapse of demand during the coronavirus crisis and the slow pace at which output was curtailed. Although they have since fallen, they are still relatively high. Total oil inventories in the US – i.e. crude oil and products, excluding strategic reserves – stand at about 7–8 per cent above the five-year average.

Weakened US producers

But why is the oil price not expected to slide further? The reason is the reduction in activity by US shale oil producers, which had expanded production to extreme levels in recent years but were severely affected by the price slump. They have found it much harder to obtain funding since the coronavirus crisis, so they are unlikely to return quickly to the market when prices rise. This can also be seen from the rig count. Around 250 drilling rigs are currently still active, compared with approximately 800 at the start of the year. So if demand stabilises, they are fairly unlikely to increase supply. The US fracking industry has therefore ceased to be the ‘swing producer’, at least for the time being. Moreover, oil cartel OPEC will make every effort to bring unused production capacity back on stream when demand rises, enabling it to recapture market share.

Supply discipline by OPEC+ halts the price collapse and restores equilibrium in the oil market

US inventory
örderdisziplin der OPEC+ stoppt Preisverfall und bringt Ölmarkt wieder ins Gleichgewicht
Sources: IEA, Union Investment; ast at 18 September 2020

However, for this to happen, a vaccine is required that will enable the pandemic to be brought under control on a lasting basis. Each new restriction on economic activity depresses demand for oil, as transport and industry are still heavily reliant on this commodity. Union Investment currently estimates that the oil price will only start to rise again in a few months’ time. A price of US$ 50 per barrel of North Sea Brent crude should be possible in autumn 2021 and may increase further by the end of the year.

The oil market is a barometer for the coronavirus pandemic. Another price slump is only likely if infection rates surge again and new lockdowns are imposed that put the brakes on growth.

Max Holzer

The oil market is a barometer for the coronavirus pandemic. Another price slump is only likely if infection rates surge again and new lockdowns are imposed that put the brakes on growth. However, oil-producing countries are likely to counteract this by further curtailing their output or output will fall as a result of US fracking companies being forced out of the market due to an ability to obtain funding. The factors that will determine prices are thus discipline on the supply side and the rate at which oil inventories are depleted. The sustained recovery of prices is not anticipated until the second half of 2021.

The futures curve explained

Two futures curve structures can be found in the oil and commodity markets. Contango is when prices for delivery in the short term (spot price) are lower than the prices for delivery at a later date (futures price). The reason for this is usually because excess supply is depressing the price or future storage and freight prices have risen sharply. This means higher costs for investors who use futures contracts to speculate on price movements. When the current futures contract expires, the investor receives less money than is needed to invest in the next, more expensive futures contract; this is known as a ‘roll loss’. The contango phenomenon was extremely pronounced during the coronavirus crisis due to a price war triggered by Saudi Arabia, one of the biggest oil-producing countries. On 20 April 2020, the price of crude oil with a May delivery date dropped into negative territory (minus US$ 37.63 per barrel of US WTI) whereas the price for delivery in June was in positive territory at US$ 20.43 (‘super contango’).

Backwardation is the opposite of contango and means that the price at the short end is higher than the price at the long end. This is preferable for investors. Whenever a futures contract expires and has to be sold, more new futures contracts can be purchased with the sale proceeds because they are cheaper, resulting in a ‘roll gain’.

 

As at 18 September 2020