If anyone needed a warning that we are living in unprecedented times it was delivered yesterday. Last week’s optimism was nowhere to be seen and risky assets were disposed of once more. There is no beating around the bush, there is a very clear and present danger that Covid-19 will paralyze part of major economies as stricter restrictions and regional lockdowns are to be introduced. The regional government in Madrid requested help from the army to fight the pandemic, Greece registered a record number of daily cases, the UK government contemplates a national lockdown and the US confirmed cases are now close to 7 million. As the fragile global economic growth is in jeopardy investors shunned equities. Major US stock indices lost more than 1% of their values yesterday. The silver lining is the daily death rates remain relatively low and this might lead to comparatively short-term social and economic curbs.
Demand considerations battered oil prices, too. Heating Oil and RBOB were leading the way lower with daily losses of more than $2/bbl equivalent whilst WTI fell $1.80/bbl on the day. Supply developments also played their parts in yesterday’s sell-off. The nascent recovery in Libyan oil production after the months-long force majeure was lifted added to the bearish sentiment. The Sharara oil field has restarted operations and an oil tanker was on its way to the country’s Marsa El Hariga terminal, Refinitive shipping data showed. According to Libya’s NOC output could jump to 260,000 bpd next week. The resumption of production makes oil bulls worried, however, judging by past occurrences reaching the pre-blockade output level will be anything but plain sailing. Yesterday’s weakness could well turn out to be a temporary, albeit painful, dip.
A substantiated but unlikely bullish scenario
If predicting future were simply science and would not have an artistic element in it, life would be simpler but at the same time more boring. All one would need to do in the utopian world of oil price forecasting is to use statistical tools to look for past relationships and employ these findings to calculate future prices – very similar to machine learning and the use of big data. There are, however, myriads of variables that cannot be considered or modelled in a formula or equation, therefore the end result turns out to be unreliable and inaccurate most of the time. Nevertheless, a fact-based approach that relies on past changes can be a helpful tool to form a view on futures developments.
Oil prices are greatly influenced by global and regional supply and demand data and the differences between the two. These differences ultimately lead to stock movements – when supply exceeds consumption oil inventories rise and vice versa. Historical data suggests that oil prices faithfully follow the fluctuation in OECD stock levels. Obviously, comparing oil price movements with changes in worldwide oil inventories would be a more trusted approach but reliable data on the latter is hard to come by. Estimates on OECD inventories are the next best thing – and they show a relatively close reverse relationship with front-month Brent. On a quarterly basis going back to 2007 oil prices and OECD oil inventories have shown an inverse correlation of 80%. On the way up to $147/bbl, in 2Q 2008 OECD inventories fell to 2.5 billion bbls whilst Brent averaged at $123/bbl. An opposite example is much fresher in our minds: in the second quarter of this year oil stocks rose to 3.2 billion bbls and this gigantic build sent the price of the European benchmark down to $33/bbl on average.
A reasonable approach in forecasting future oil prices is to establish how they reacted in the past to, say, a change of 1 million bbls in OECD inventories. Averaging out the results will help compute rough estimates. It makes sense to take into consideration seasonality, ie. always compare the same quarters on an annual basis. Available projections that run until the end of 2021 provide us with useful data in calculating the daily changes in global oil inventories based on assumptions of an OPEC output that relies on the current OPEC+ agreement. As a rule of thumb one can say that about 40% of the changes in global oil inventories takes place in OECD countries. Absolute stock levels then can be obtained by inserting the known variables in a simple formula. Using data from the latest Monthly Oil Market Report published by OPEC last week the result for 2021 is nothing short of mega-optimistic.
As both the recovery in oil demand and OPEC+ quota compliance are currently underway OECD inventories are set to fall very close to 3 billion bbls in the last quarter of this year. Although this is an impressive improvement on 2Q and even on 3Q it is still above the comparable period of 2019. Our formula shows that Brent ought to average around $41/bbl, some $22/bbl below the 4Q 2019 price level.
The real improvement starts at the beginning of next year. The first quarter will see a slight year-on-year deficit in OECD stocks, consequently, prices should average around $10/bbl above 1Q 2020, close to $60/bbl. As global demand is expected to rise further and OPEC is determined to stick to the output agreement the depletion in OECD inventories accelerates and the quarterly deficit from 2020 widens to 400 million bbls in 2Q and 3Q and narrows to 300 million bbls in 4Q. In an ideal world it would mean a pop over $100/bbl in the middle of the next year only to retreat below this milestone towards the end of 2021.
The oil market is much more complex than a simple formula; it is impossible to price in market sentiment and the known unknowns. OPEC discipline might get looser or involuntary cuts can disappears – a stark reminder of the latter came from Libya over the weekend and resulted in a sizeable sell-off. The higher prices go the more non-OPEC producers will likely to pump and one must not forget the biggest of unknowns: failure to contain the coronavirus will lead to significant downward revisions in oil demand making any notable oil stock draw nothing more than wishful thinking. The current snapshot, however, reveals a bright future but undoubtedly our magic formula will be altered several times in months to come.