According to key conclusions in a recent assessment from IHS Markit, oil markets can expect more pain to come in the weeks and months ahead as they face an uphill battle back to “normal.” The raw market forces that have been unleashed – record demand destruction, record supply cuts, record inventory builds and even, for a moment last month, negative oil prices –will change the fundamentals of supply and demand for years to come.
The report maps a long-term path marked by three distinct phases, which mark the trajectory of oil market fundamentals and prices over the next two years.
“It may be hard to comprehend now, but barring a second wave of the pandemic, nearly all pre-COVID demand could return by the second half of 2021,” Roger Diwan, Vice President of Financial Services, IHS Markit, said. “If that transpires, it could even lead to a market squeeze in the medium term as supply destruction hinders the ability of supply to keep up with recovering demand.”
“But make no mistake, the road to oil price recovery will likely be choppy and plagued with stop-and-go rallies and selling cycles until some level of certainty is restored,” Mr Diwan added.
IHS Markit stats that the three phases of oil markets recovery include the crash correction phase (Q2 2020), the just-in-time oil market phase (Q3 2020 to the first half of 2021) and the structural recovery phase (second half of 2021).
In the crash correction phase, the balancing process is well under way: shut-ins of supply, managed or unmanaged, have started to materialize in April and May, and 13-15 million bbl/day of crude production will likely be removed from the supply stack in the next two months while demand is showing some improvement from the abyss it reached in the second week of April. The massive inventory overhang amassed onshore and offshore over the past few months will weigh heavily on markets and will not register material declines until late June or July.
In the just-in-time oil market phase, prices will be governed by the unstable balance of an uncertain demand recovery and the record amount of supply on the sidelines. The length of this cycle will largely depend on the shape of the pandemic over the next year and the feedthrough to behavior and economic activity around the world. While the impact of testing, tracking and vaccinating against this virus may seem indirect on the surface, they will be the most important elements in providing a predictable future for the oil industry.
In the structural recovery phase, demand comes back to 96-98% of pre-COVID-19 levels and the progressive de-stocking of the oil supply chain allows a large share of productive capacity on the sidelines to come back into the market. Barring a second wave of the pandemic, this recovery could start to materialize a year from now. This phase could set the stage for a market squeeze in the medium-term as supply destruction hinders the ability of supply to keep up with recovering demand.
The IHS Markit Brent crude price outlook has been revised down to $35/bbl in 2020 and $44/bbl in 2021, with more downside in 2020 should the demand doldrums drag into the fall and upside in late 2021 should the inventory overhang get digested and structural tightness take hold.
This recovery path would create the necessary conditions for an increase in Persian Gulf and Russian production, as well as a return to growth for US shale.
For that to happen, Russia and Saudi Arabia will have to agree on how to bring spare capacity back to the market, at what price and how to accommodate the US shale industry. Market share concerns will resurface as soon as Brent prices pass the $40/bbl mark, probably before the end of 2020. This will put OPEC+ compliance in the spotlight as the demand “enforcer” fades and logistical bottlenecks ease, leaving Saudi Arabia, its Gulf allies and Russia once again to shoulder an increasing share of the cuts burden. How they respond will be critical. Faced with a similar trade-off in 2016, Saudi Arabia opted for short-term relief over lasting price benefits and ended up stuck in an endless loop of cuts. Will the calculus change this time around?
“Facing a demand crisis of uncertain parameters, the skew of risks is likely on the downside in the short-term should demand’s recovery underwhelm, and to the upside towards the latter part of our outlook as the physical reality of the supply destruction becomes clearer,” Mr Diwan said.
“It is important to remember that this is an unprecedented crisis,” he added. “While fundamentals do point to structural improvement ahead, some of the oil market’s foundational tenets could crumble by the time the dust settles on the COVID-19 pandemic.”