While it won’t be all about the Coronavirus outbreak currently crippling China’s economy, the pandemic and a whole host of scenarios could play out and come together all at once to drive the oil price down below $30 per barrel levels.
Such a drop has happened recently in very different circumstances. In 2016, a full blown supply glut transpired when U.S. shale output continued to pick up and Saudi Arabia’s former oil minister Ali Al-Naimi kept OPEC’s taps open. As a result, on Friday, January 15 that year the Brent-West Texas Intermediate spread was barely distinguishable at the end of the week with Brent closing at $29.25 per barrel and its American benchmark counterpart at $29.72.
Since it was oversupply sentiment that knocked market confidence four years ago, the mood music was swiftly improved by the then newly appointed Saudi Crown Prince Mohammed Bin Salman pushing Al-Naimi into retirement, and reaching out to Russia forming the 24-member ‘OPEC+’ group that’s still busy cutting 1.7 million bpd of production out of the global supply pool.
By the last Friday of 2016, Brent’s premium had been restored at about $3 per barrel and barrel prices were back above $55. Swatting away the latest bearish headwinds will be harder and short traders sense it. In fact, it could all get much worse.
First off, it’s a slump in Chinese demand that’s the primary bearish factor here; an economy that despite its readjustment still consumes on average 14 million barrels per day. In grappling with and getting a handle on the Coronavirus, Beijing has put millions of people in quarantine, extended the Chinese New Year holiday, and shuttered offices, factories, shipyards, shopping malls, cinemas and more.
Whole towns in Hubei province, including Wuhan where the outbreak originated have been off limits. This is likely to knock China’s demand, at least for the first quarter, by 18% to 25% according to industry surveys and the plethora of “anonymous” comments by oil executives to newswires. If pegged at a median of that range, it comes to around 3 million bpd less required by China as its economic activity declines.
That’s bearish factor one, and the second bearish factor is the domino effect of the pandemic. The outbreak has spread to over 20 countries and led to nearly 500 deaths. One clear casualty would be civil aviation not just within and to/from China but globally, with fewer travelers, higher restrictions and global health related wariness over flying.
Lower calls on jet fuel in Asia are becoming visible and many international air carriers have temporarily suspended flights to China. According to Reuters, on the U.S. West Coast, jet fuel prices have taken a severe knock as cheaper supplies are being sent into the region from Asian markets.
Jet fuel for delivery into Los Angeles JET-LA was down 25% on January, to $1.5997 on Monday (February 3) from $2.1266 a gallon. While that might make airplanes cheaper to fill up, lower number of passengers and fewer flights in its wake would again drive consumption lower. Both factors are good enough to spook the market on their own.
You’ll often hear in current market discourse that oil has fallen 20% of its peak “this year”, except that the trading year is only into its second month, and has had a short-lived rally past $70 in Brent’s case following the U.S.-Iran tiff after the killing of the Islamic Republic’s Quds Force General Qasem Soleimani in an American airstrike. Nonetheless, a drop is a drop.
The third bearish factor could be OPEC+ discord. The group’s discipline has held firm since 2016 but the Russians have over-promised and haven’t delivered. Yet, OPEC’s credibility is predicated these days on Moscow’s participation.
When the magnitude of demand destruction following the Coronavirus outbreak became apparent, OPEC+ representatives came together on February 4-5 but failed to reach an agreement on the proposed deepening of cuts by 600,000 bpd despite extending talks to a third day as the Russians blocked it. If OPEC+ discipline cracks and barrels flow market bears will have a merry dance.
The fourth bearish factor is actual global demand which wasn’t much to write home about in the first place before the Coronavirus outbreak. Demand growth expectations for 2020 were in the range of 800,000 bpd to 1.4 million bpd, with the IEA putting it in the region of 1.2 million bpd.
Many analysts, myself included, were leaning towards the lower end of market projections with the Indian economy looking dicey, and South Korea’s and Japan’s crude importation in decline since 2018. With the Coronavirus outbreak, all old projections are out of the window and 2020 may yet be the year where there might be considerably lower demand growth, negligible demand growth or even a possible decline.
Only market projection available so far is from BP, with the company noting that global demand growth could be 300,000-500,000 bpd lower than its internal 2020 projection of 1.2 million bpd. If reflected in the data, that is one-third of demand growth wiped out.
Finally, this brings us to the fifth bearish factor – supply. Lower pricing will inevitably hit exploration and production activity in marginal plays. However, where output is conventional and onstream, there is nowhere for that oil to go but out. Add to that some U.S. shale players with viable acreages and sub-$35 break-evens, run in the spirit of private enterprise that will continue to monetize their barrels.
Overall non-OPEC production could come in anywhere between 2.1-2.3 million bpd, with barrels not just from the U.S. but from Brazil, Canada, Guyana and Norway too. Combine the factors and you have demand destruction on a scale and speed that is unprecedented this century, as neither SARS (2002), Ebola outbreak (2013) and the global financial crisis (2008) can match it, and it’ll be coupled with ample barrels on the supply-side.
As Q1 2020 heads for the lowest quarters of global growth on record, there’s no sugar coating it – the oil market is staring at a proper crisis at the worst possible time and place. Should all bearish factors fall in line, many would call it a black swan event. I prefer to call it the perfect storm that’ll take prices down below $30. Maybe, one of the five factors may not materialize as possible OPEC+ action could avert the storm but even that won’t be enough calm heavy bearish headwinds.
Disclaimer: The above commentary is meant to stimulate discussion based on the author’s opinion and analysis. It is not solicitation, recommendation or investment advice to trade oil and gas futures, options or products. Oil and gas markets can be highly volatile and opinions in the sector may change instantaneously and without notice.