The outlook for oil in a period of demand destruction

May 06, 2020 | RBC Wealth Management


With oil prices in free fall as demand has evaporated into thin air, we look at what’s in store for the oil market.

The outlook for oil in a period of demand destruction

  • Confinement measures due to COVID-19 have crushed demand for crude oil and products that derive from it, such as gasoline and jet fuel.
  • The collapse occurred at a time when the oil market was already greatly oversupplied due to a lack of restraint by major oil producing countries. RBC Capital Markets, LLC global energy strategist Michael Tran believes the recent OPEC+ production cut is insufficient in the short term in light of the scale of the demand destruction.
  • RBC Capital Markets believes the outlook for oil prices remains challenged in the short term, but as economies open up, prospects should become brighter for the second half of 2020. Prices should improve further in 2021.

With crude oil prices collapsing since March and WTI (West Texas Intermediate) May futures in particular diving into negative territory for the first time ever, we asked Michael Tran for his thoughts on what’s in store for the oil market.

Global Insight: OPEC put together a historically large deal recently, announcing a 9.7 million barrel per day (b/d) production cut. But oil prices have continued to move lower. Was the cut not big enough? Is there still too much excess oil in the market?

Michael Tran: The OPEC deal was certainly historic in terms of sheer size and duration. But despite it, oil prices have traded materially lower, a sobering reminder that oil demand destruction remains on center stage.

COVID-19 has completely taken the oil market hostage, and the near-term outlook continues to be quite grim. The degree of demand destruction is the greatest that we’ve seen throughout our careers.

Oil is trading at multi-decade lows right now, with WTI May futures even diving into negative territory at one point in April. But the medium- and longer-term oil outlooks do look brighter, thanks to the recent deal. The production cut is not only sizeable but also has a long duration spanning two years.

Thanks to the deal, in the medium term we’re not going to build crude inventories to the point that global storage capacity, and I stress global, is challenged. It was nearly a foregone conclusion in early April, before the OPEC deal, that we would fill global storage to the brim. The deal allows the oil market to dodge that inventory iceberg we were previously heading straight for. We estimate that there is about 1.5 billion barrels of onshore storage capacity remaining today globally.

We anticipate that we will fill nearly 1.1 billion of that this quarter. But the reprieve really starts coming by midyear. Assuming that COVID-19 tapers, we’re modeling inventory drawdowns in the following six quarters.

So thanks to the OPEC deal, the oil market has a materially brighter outlook once we get to the second half of this year and into next year, as we don’t see the market filling inventories to the brim on a global basis anymore.

You mentioned that demand destruction is the key driver for oil markets right now. You’ve done some compelling work on tracking real-time data. Can you highlight some of your findings?

When COVID-19 first came on the scene earlier this year, we immediately engaged our data science team, RBC Elements, to try to track real-time data on human activity and use that to lead our analysis, our work, and our thought process.

We spent a considerable amount of time building out our artificial intelligence system to the point where, for the past several months, we have been able to track flight activity to and from every major airport on the planet. We’re also able to track vehicle trends for every major city on earth. In short, we can track indicators of human activity, and we can quantify how low activity anywhere is.

For example, U.S. vehicle congestion is down 83 percent from normal at the moment. Outside of the U.S., global cities ranging from Singapore to Paris to Sao Paulo have seen vehicle congestion down by 85 percent to 95 percent. This analysis allows us to say with a degree of precision that global gasoline demand is down by about 15 million b/d right now.

In addition, our weighted average flight activity index, which measures major European and Middle Eastern flight hubs, is down 91 percent. A whopping 84 percent of Asian flights and 71 percent of American flights are currently canceled, truly staggering figures, which by our modeling suggests that about 4.1 million b/d of global jet fuel demand is currently being destroyed.

So major drivers of oil demand have come to a screeching halt. U.S. crude demand has fallen to the lowest point in a decade. Oil prices are low for a good reason.

Earlier you mentioned oil storage approaching capacity limits. Can you elaborate a bit more on the implications of such an event and also touch on U.S. shale production?

The topic of U.S. storage levels approaching capacity limits is the biggest concern in the oil market. To be clear, earlier we talked about how on a global basis, we no longer think that oil storage will hit global capacity constraints. But in the U.S., it is very different, as we are already testing congestion levels.

In mid-April, the U.S. government data showed that domestic refinery runs fell to the lowest point in over a decade—this is essentially crude oil demand. Earlier that week, the U.S. Department of Energy showed that domestic crude inventories had surged by a record 19 million barrels. The coming several weeks will likely look similar.

The barrels are piling up into storage at the fastest pace that we have ever seen. This is almost like watching a slow-motion car crash where the degree of inventory builds are outpacing the U.S. shale production cuts.

What happens when we start testing tank tops? As barrels have nowhere to go, prices collapse, and production ultimately has to be shut in. The U.S. government has been batting around a number of different ideas to try to help the oil industry, such as buying barrels to fill the Strategic Petroleum Reserve, potentially putting tariffs on crude oil imports into the U.S., or even potentially paying producers to leave the resource in the ground. Unprecedented times call for unprecedented proposals.

Some of the proposals are more elegant than others, some potentially more effective than others. But the bottom line is that as the U.S. inventory fills to the brim, we need to turn off the taps before the bathtub overfills.

Oil prices will remain extremely challenged over the near term.

What’s the blueprint for how oil prices recover from here?

The rebound will come at some point. We anticipate midyear. We need the economy to open up once COVID-19 clears. Once it is in the rearview mirror, as we all start driving more and resume daily life, gasoline demand will pick up. Once gasoline demand picks up and we’re driving more, we’re all consuming more.

Then refining margins will start to expand, and refiners will start to turn on the lights again and run more crude. As a result of that, crude demand will pick up.

Once we look at that framework and we add on the idea that OPEC compliance will likely be airtight in the second half of the year, we see prices averaging $31/b and $35/b through the balance of this year for WTI and Brent, respectively, before increasing to average $44/b and $46/b next year.

So after a very volatile 2020, we think that 2021 looks much more balanced from a fundamental perspective.

We see the recovery in prices from here being a slow, tepid one because OPEC+ wants prices to remain low enough to prevent that resuscitation of U.S. production growth. So the market will look to price at a level that remains challenging enough to U.S. shale economics to ensure the barrels remain sidelined.

The Wall Street Journal recently wrote a profile about how you were able to call the COVID-19 turning point for China because you were leveraging your real-time data analytics. Can you talk us through the green shoots in oil demand using China as a framework?

We published a report in early March focusing on China and highlighting that many of the indicators of human activity were picking up strongly. After the country was shut for several months, the Chinese government opened up the economy.

We saw an almost immediate pickup in activity at the five biggest ports in China, which we track using geolocation data. It swiftly returned to normal. This is important, as we used port activity as a proxy for Chinese trade.

Also, we tracked traffic patterns on an hour-by-hour basis. The vehicle congestion activity in Beijing and Shanghai as well as a number of other Chinese cities has now reverted to near normal levels on weekdays.

However, while driving in many cities in China seems to have reverted to near pre-COVID-19 levels on weekdays, we are detecting very, very low levels of vehicle traffic and congestion on weekends.

My read of this is that activity has picked up as the Chinese government has sent employees back to work, but discretionary driving on weekends remains very minimal. We have observed across several Chinese cities that people don’t travel if they don’t have to.

Wuhan recently reopened its economy in mid-April, and we’re already seeing a pickup in traffic activity there. That’s really promising for forecasting oil demand in China.

Chinese flight activity has rebounded off the February lows when roughly 75 percent of Chinese flights were cancelled—only 63 percent of flights are cancelled today. A clear bounce but far from returning to pre-COVID-19 levels. We would anticipate jet fuel to be the last of the major fuels to rebound compared to gasoline and diesel.

This interview was edited and condensed prior to publishing.

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