Coronavirus: How This May End for Oil Prices

On February 11, I predicted that Coronavirus would crush oil prices. Prices collapsed on February 20. Today, prices have reversed and WTI price is $2.00 higher on expectations of an OPEC+ production cut and central bank stimulus. Rising and falling sentiment about Coronavirus will be the framework for the rest of 2020.

As of last Friday, WTI prices had fallen 27% and Brent had fallen 15% since late December. Price increased on Monday, March 2 but oil price is being devalued despite today’s gains. Most of this is because of lower demand expectations and disruption of supply chains from Coronavirus (Covid-19).

Hope versus reality will be the manic pattern for 2020. The optimistic rebound of price during the week ending February 14 was short-lived and turned to capitulation the following week. WTI price dropped $8.62 and Brent fell $7.98 (Figure 1).

Figure 1. Hope versus reality will be the manic pattern for 2020. Brent price rose +1.38 (+2.7%) on March 2 on expectation of OPEC+ cuts & bank stimulus
but price fell -$8.79 (-15%) after February 20. Source: Quandl and Labyrinth Consulting Services, Inc.

On March 2, Brent price rose by $1.38 (2.7%) on expectation of OPEC+ production cuts and central bank stimulus plans but longer market players aren’t buying false hope. Brent 12-month spreads fell 94% deeper into contango (Figure 2).

Figure 2. Brent longer market players aren’t buying false hope of production cuts and bank stimulus. Price rose 2.7% on Monday, March 2 but 12-month spreads fell $0.18 (-94%) to -$0.37. Source: Quandl and Labyrinth Consulting Services, Inc.

Markets seem to be reflecting two contrasting themes . Collapsing prices are recovering based on hope but spreads are more faithfully reflecting market fundamentals namely, that demand destruction cannot be fixed with bandaids. The worst effects of the Coronavirus on oil markets persist although may not be quite as serious as originally thought in early February.

As consensus builds toward Coronavirus apocalypse, short-term oil traders can easily find counter-parties to take the other side of a bet that prices will probably improve over the term of a contract. This pushes prompt contract prices down. Meanwhile, longer-term players may be able to see their way clear to an upturn in prices later in 2020 or in 2021 but for now, they recognize that neither OPEC+ nor central bankers can make the economic effects of Coronavirus magically disappear.

While the news about Coronavirus and its effect on oil markets is bad, there are some hopeful elements that may explain how markets are reacting now. Figure 3 shows that the number of cases in China appears to be leveling off and that people who have recovered is increasing. The scale of the chart under-states the expansion of cases outside of China. Still, the data suggests that fears of an apocalyptic pandemic may be exaggerated.

Figure 3. COVID-19 cases and recoveries. Source: Johns Hopkins and Labyrinth Consulting Services, Inc.

At the same time, Chinese data is suspect and confirmed cases are rising quickly outside China. Some people are returning to work in China but baseball stadiums are empty in Japan and Italy is looking a lot like the China of two weeks ago with quarantines and growing concerns.

Negative world demand growth is likely for 2020 (Figure 4). This optimistically assumes that only demand from China is affected and that a decrease of 200 million barrels for the first quarter is followed by recovery in the rest of 2020.

Figure 4. Negative world liquids demand growth is possible in 2020 (-0.3 mmb/d): -2.2 mmb/d in the first quarter of 2020 and -0.3
in the second quarter followed by weak but positive demand growth in the second half of 2020.
Source: OPEC, EIA, Vitol and Labyrinth Consulting Services, Inc.

That would result in the first quarter of negative demand growth since the 2008 Financial Collapse and the first year of negative demand growth since 2009. The “knock-on” effects of broken supply chains and demand destruction outside of China would result in an even more pessimistic, if more probable, forecast. In either case, it is unlikely that oil prices will recover substantially from current levels in 2020 or that Coronavirus will become a distant memory.

The near term is anyone’s guess at the moment but it is probable that the panic will be worse than the pandemic. I can imagine a scenario in which prices continue to fall from current levels but start to stabilze.

Comparative inventory suggests than the current WTI front-month price of about $47 is under-valued by at least $8 per barrel. I don’t believe that sentiment alone is responsible for this. Markets are assuming a substantial inventory build once lower demand begins to affect shipments at least for U.S. stocks. The price is still under-valued because inventory build will probably be more gradual than price anticipates.

I can also imagine a scenario in which panic drags near-term prices into the $30 to $40 range. That would probably not be sustainable for very long.

Whatever the short term brings, WTI prices should stabilize in the low- to mid-$50 range sooner than later, and move slowly higher as the emerging effect of Coronavirus on oil markets and the economy becomes clearer. Once this happens, prices will rise and fall on daily news that is either more or less hopeful about the impact of Coronavirus on demand and supply chains. That period of flux may last for 18 months or longer.

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