Kronos Management | April 24, 2020
In January we wrote about oil’s lack of upside catalyst. The chaotic drop of WTI May contract to -$40.32 on April 20 was headline-worthy and reminds us of the grim time ahead in the oil market. This time we take a quick look at how prices might recover.
The immediate demand destruction related to coronavirus is at least 25 million barrels a day (mbpd). The ferocity of the drop prompted a chain reaction from OPEC + Russia to pledge a production cut of 9.7mbpd starting in May 2020, tapering to 5.8mbpd toward 2022. The Texas Railroad Commission has not yet decided on the necessity and legality of a coordinated cut. Where does that leave us?
Numerous factors and second order effects will be at play and hence will lead to a wide range of outcomes. The timing of the economy opening, the compliance level of OPEC+ cut, and the responses of U.S. and other producers will be the key.
On the demand side of the equation, the US being the biggest consumer is indicative of the magnitude of the crash. While diesel is still holding up (industrial, shipping), gasoline output from US refiners has declined 40% since January and continues to slide in April. Refinery utilization has dropped to 70% in March and counting.
Worldwide, analysts’ estimated demand contraction in 2Q20 ranges from 15mbpd to 25mbpd, and is generally followed by a steep recovery toward 2Q21. The path varies as there is an inherently large degree of uncertainty on the timing of vaccine development and structural and behavioral changes coming out of the recession.
On the supply side, producers have to deal with fairly complicated game theory while balancing their own survival and long-term goals. While Saudis and Russians both have about $500 billions of foreign reserves – enough to sustain a price war for many months, painful reforms and prolonged belt tightening will push their political regimes to the limits.
|OPEC+ Cut Framework||May-Jun 2020||Jul-Sep 2020||thru Apr 2022|
|Production Cut (mbpd)||-9.7||-7.7||-5.8|
OPEC and Russia plan to begin cutting in May. Assuming 70% – 80% compliance level given recent history, we should see 200mb+/month reduction and then taper toward 100mb+/month by year end. Given the speed and magnitude of this cut, and considering many OPEC members and Russia’s oilfields are mature, shutting in that amount of oil will be expensive and may result in permanent loss of capacity. This compliance level could be optimistic and we fully expect Russia to half-comply out of self-interest. Regardless, with storage running out some production from everyone will be shut in temporarily when tanks overflow.
U.S. producers do not operate according to national planning. With equity and capital markets essentially closed off to shale producers in recent years, there is little room to maneuver. By mid-April, public companies have cut capex by 50%, dropped 28% of rigs, and delayed well completion by 35% with more to come. According to EIA, close to 1mbpd of U.S. production cut has occurred by mid-April with export down 0.5mbpd. Analysts are forecasting market-forced well decline or shut-in of 3mbpd before the year is over. Other non-OPEC producers will face similar pricing pressure and physical constraints but we estimated about 1mbpd of collective cuts by others in 2020.
No one truly knows how much storage is available globally. Estimates by different analysts point to 1.5 to 1.8 billion barrels and around 60% +utilization by the end of March. That leaves about 700mb+ available for commercial use. The U.S. strategic petroleum reserve has some 70mb spare capacity (less than a week of production) and may be available. China has been building up reserve since 2015 and may use this opportunity to stock up. Word on the street is that the Saudis have locked in most of the available tanker space as they started to flood the market a few weeks ago. Landlocked crude like Cushing, Canadian, Russian will be hit harder than seaborne ones like Saudi, Mexican, Nigerian etc. But that’s the detail.
Given the ferocity of this drop we expect global storage to fill up in May, leading to another contango blowout for the June contract (already happened for May contract). The question is what happens next.
In a highly benign V-shaped recovery scenario, we expect an average of 8mbpd of inventory build in Q2, followed by drawdown as soon as Q3. A lengthy shutdown of the economy (L-shaped scenario) could see persistent inventory continue to build through Q3/Q4. However, the lack of storage will force a more severe cutback, and the way it unfolds will be highly dependent on regional logistics.
Obviously, the situation is highly fluid. How hard will demand bounce back? Will the economy be opened in stages? Will enough people have jobs to resume spending? Will OPEC members cheat on quota? How much will U.S. producers consolidate? Will commute behavior change forever? Keep in mind that air travel took three years to recover post-911.
Markets don’t necessarily bounce back when the end is in sight; they typically move toward equilibrium when tail risk can be visualized and priced. In this case, clarity can be attained not when a vaccine or treatment is available. As soon as the large economies open and the duration of supply/demand imbalance can be estimated by observing consumer behavior and trends of supply reduction, prices can stabilize. Some analysts are even predicting a price spike in Q3 due to future shut-in related reservoir damage and pent-up demand. We posit that the large inventory overhang and damage to the economy will act as a powerful ceiling to any such move.
Kronos Management, LLC
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