The week started on the back foot but two developments, neither of them oil-related but one of them conclusive, helped prices recover from the initial dip. At this stage not much should be read into the strength in the latter half of the session as the market failed to break above recent highs and remains stuck in the current trading range.

The first level of support came from promising results in the first phase of a trial of a coronavirus vaccine developed by Oxford university and AstraZeneca. Hopes are rising that the disease might be prevented but it will take months to thoroughly test the safety and effectiveness of the vaccine. Nevertheless, encouraging initial results helped change the sentiment.

Investors also found comfort in the marathon meeting of EU leaders on the post-COVID economic recovery plan. The fact that talks did not break down after four days of mud-throwing and mutual accusations was seen as positive and implied that member countries were edging towards an agreement. In fact, a deal was a must otherwise the existence of the European Union would have been questioned with all its economic consequences. At 4 am this morning a compromise has been reached on how to split the €750 billion to assist virus-stricken economies. A layer of uncertainty has been removed and the agreement supports equities, as well as oil this morning.

There have been several unsuccessful attempts in the better part of the last two months to make the next bigger move. Buyers and sellers, however, have been kept in check. The next impetus will come in the form of the latest weekly update on US oil inventories. Whilst draws are expected across the board demand figures will also be closely watched. Should gasoline consumption decline due to the flare up of infections in several US states re-visiting the bottom end of the current range cannot be excluded.

Slow but steady progress

The OPEC alliance will be disappointed with the market reaction to the latest output adjustment. When the producer group raises production, it is usually viewed as a negative development, but this time it should have been different. After all, global oil demand is improving by leaps and bounds. In the second half of the year the world will need 12.22 mbpd more oil than in the disastrous second quarter. This growth rate compares to the 2 mbpd easing in production constraints, which is even less as countries that overproduced in May and June are obliged to compensate in coming months.

There are two reasons behind the lukewarm reception of the new and slightly higher production ceiling. The first one is that this year’s oil demand destructor is still running free. The virus has not been contained and this makes oil investors rightly cautious. The second one is that although significant stock draws are expected in the second half of the year global and OECD oil inventories will still be higher than at the end of 2019. According to the EIA end 2020 stocks in the developed world will be just over 3 billion bbls, 132 million bbls above the year-ago level. It will be sufficient to cover 68 days of OECD demand. This indicator stood below 61 days at the end of last year.

Consequently, no significant rally is anticipated this year and if the virus keeps spreading globally negative demand consideration could easily send prices back to $30/bbl. The good news is that next year looks markedly different, especially the second half of it. Impressive improvements in oil demand as well struggling growth in oil supply coupled with persistent OPEC+ output discipline should lend significant support. Global consumption is to increase 6.5 mbpd year-on-year, consensus figure shows. Oil demand in 2H 2021 is expected to jump 4.3 mbpd from the same period of this year.

On the supply front non-OPEC production is to rise much less than consumption – it is pegged at 900,000 bpd on the year. This less-than-enthusiastic growth rate shows that the outbreak of the pandemic and the resultant output war that sent oil prices to lows not seen for 20 years (or in the case of WTI to negative territory) have done severe harm to global supply. In the case of the US shale industry the damage is irreversible. Several industry leaders now concede that the recent high of 13 mbpd of US oil output is unlikely to be matched. Long-cycle exploration and production projects will also suffer from setbacks because of spending cuts. The world’s oil reserves deplete at the rate of 4-7 mbpd, depending on which study one looks at. If these reserves are not replaced there is a natural shortage in the market.

And finally, OPEC. The current agreement will not end this year, it will run until at least the end of the first quarter of 2022. If the original deal is observed the reduction from the October 2018 baseline will be 5.8 mpd for 16 months starting January 2021. OPEC’s share of it will be 3.6 mbpd, ie the 10 member countries with quotas will be bound to produce just above 23 mbpd. Add to that the current output levels of the exempted countries (around 2.4 mbpd) and you will end up with 25.4 mbpd. Set this figure against the projected OPEC call of 29.6 mbpd for next year and 30.1 mbpd for 2H and the result is a significant supply deficit with meaningful stock reductions. For the whole of 2021 it is 4.2 mbpd and for the second half of the year it is around 4.7 mbpd. With disciplined output management OPEC could even find room to allocate extra barrels that might come from Iran, Libya or Venezuela.

The final and most important piece of the next year’s oil balance jigsaw puzzle is the change in absolute stock levels. Historical evidence suggests that around 40% of changes in global oil inventories takes place in the OECD region. This means inventories in the richer part of the world could fall significantly below the end 2019 level. The real re-balancing will start taking shape from 2021 and accelerate in 2H of next year. Of course, OPEC+ must remain committed to the agreement and if they do, they will reap the benefit from next year. It is perhaps no coincidence that the December 2021/December 2022 Brent spread has started to strengthen lately. It has been climbing steadily from the April low of -$4/bbl and is now above -$2/bbl. As the global stock fall accelerates in 2021 it should flip into backwardation whilst outright prices could easily exceed this year’s highs achieved in January, just before the pandemic struck.