Markets work in mysterious ways. The epidemic that originated from China shows no signs of abating yet risky assets performed one their biggest daily jumps yesterday. The US stock markets strengthened around 5% yesterday and European stock index futures are also on the rise this morning. Oil tracked equities and WTI gained nearly $2/bbl to settle at $46.75/bbl. Brent closed at $51.90/bbl, a daily advance of $2.23/bbl. The splendid performance came despite the day started on a negative note. The main oil futures contracts all broke below Friday’s settlement prices before they staged an impressive recovery and jumped more than $4/bbl from the early morning dips.
Optimism grew as central banks and finance ministers appear to be ready to provide whatever support is needed to combat the negative economic impact of the crisis. The BOJ, the ECB and the Fed are all prepared to take action to stabilize markets. This means rate cuts. G7 finance chiefs will release a statement today about the measures they plan to take to mitigate the impact of the coronavirus. Oil received additional boost from the latest Reuters survey, which put OPEC’s February production at 27.84 mbpd, a monthly fall of 510,000 bpd exclusively thanks to the significant dive in Libyan output.
In the meantime COVID-19 has infected nearly 90,000 people worldwide by now and resulted in more than 3,000 deaths. It is spreading faster outside China than in the country of origin. The greatest concern is the epidemic in Japan, South Korea and Italy. In the US six people died of the virus yesterday and the UK prime minister warned that it could be months before the epidemic peaks. Yet in the battle between hope and facts the former had the upper hand yesterday.
The world is currently facing two types of shocks – supply and demand. This has been laid bare by the recent fall in stock markets, dismal manufacturing data and expected downward revision in global economic growth – the global economy is registering its slowest expansion since 2009, the OECD predicts as it cut the growth rate from 2.9% to 2.4% for 2020. When the economy is struggling central banks step in and do their best to provide monetary stimulus. The most obvious tool to do so is lowering interest rates. Under this scenario the incentive to save is reduced and spending is encouraged. Borrowing costs will be cheaper, paying debts off easier and asset pricing would be expected to rise – the economy would get an adrenalin short. However, in the case of the current crisis it is not guaranteed to work for two reasons. Firstly, global interest rates have been low for years now as central banks have attempted to provide support for the ailing regional economies. The room to reduce them further is very limited.
Secondly, the current crisis is caused by the coronavirus and not by excessive risk-taking or lax financial regulations like 11 years ago. No monetary policy can mitigate its impact. It is putting towns in lock-down, closing schools, offices and factories, creating quarantines, grounding airplanes and disrupting supply chains. Only when the fight against the latest disease proves successful and effective monetary stimulus will be functional. Even then the upside reaction could turn out to be overoptimistic as the long-term impact of the epidemic might easily be much worse than originally predicted.
The demand shock is tangible in the oil market. Last month’s supply-demand reports perfectly reflected the fears of global downturn. Global oil demand for the first half of this year was revised down by 620,000 bpd on average whilst Chinese demand by 320,000 bpd. Given that the outbreak has only gotten worse over the past three weeks further downward revisions are expected this month. When global oil demand is destructed a reduction of the same extent in oil production must be implemented in order to prevent supply excess. This is exactly what OPEC has been trying to achieve. Initial estimates have roughly halved the 2020 global oil demand growth of 1 mbpd. OPEC was quick to suggest a further reduction of 600,000 bpd in the OPEC+ group oil production. It was not supported by Russia and nothing has been done. Oil prices have been falling further as the epidemic spread all over the world and the voices of those who are forecasting no demand growth at all now are getting louder. The oil group, led by Saudi Arabia is upping the ante accordingly and now a reduction of 1 mbpd is under consideration in the run up of the next producers’ meeting this week.
Assume the latter scenario – no demand growth and 1 mbpd OPEC+ cut. An absolute demand figure of 100.18 mbpd will be set against a non-OPEC supply + OPEC other liquids of 72.33 mbpd. (These are average estimates from the three agencies from last month.) These will leave the word demanding 27.85 mbpd of oil from OPEC this – around 27 mbpd for 1H 2020 and 28.70 in the second half of the year. The only question is what the 1 mbd extra reduction would be from; December last year (29.37 mbpd) or January (28.86 mbpd)? (For the purpose of this exercise the whole reduction is reflected in OPEC production figures and non-OPEC estimates are left unchanged.) If OPEC managed to get down to 27.86 mbpd (last month’s level, according to the Reuters survey) they seemingly might be able to match the fall in demand. There are, however, two strings attached to this calculation. The first one is that even if implemented it will still leave the first half of the year with a massive stock build. The second one is that the proposed cut more or less equals the unintentional loss of Libyan barrels. If or when the North African member state normalizes output, it will be literally impossible to accommodate these barrels.
The relief rally is considered a correction – from the technical as well as the fundamental point of view. How long it will last is anyone’s guess. It could easily turn out to be almost as vicious and violent as the price fall of recent weeks. The right question to ask is not where the market turns south again but when. This week’s OPEC+ gathering will provide a partial answer. Then investors will have to deal with the monthly reports that are likely show further downward revisions in global oil demand growth. Global growth estimates, consumer sentiment forecasts and manufacturing data in coming weeks and month will also shape investors’ attitude. As encouraging as the ongoing turn-around seems the economic damage caused by the virus outbreak is likely to be more severe than presently anticipated.