Oil: the worst is behind us

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Crude oil has been rallying on early signs of a demand recovery, less-than-expected demand losses and easing stock builds. While short-dated oil prices are likely to remain highly volatile, longer-dated oil offers significant upside potential as markets are expected to be undersupplied in 2021.

While the general consensus expected a 25-30 million barrels per day (mbpd) decline in demand for April, these declines now seem to be ranging between 18-20 mbpd. In addition, lockdowns in Asia and Europe are being lifted a bit earlier than expected, refinery runs are picking up on improving refinery margins and OPEC and Non-Opec have started to implement production cuts in May. This is why fears are easing that the world will run out of storage space for oil. Since we saw the largest inventories build-up ever recorded, this also means that we are likely to see the largest inventory drawdowns starting at the end of May. The steep decline in US oil rigs indicates that US oil production should fall by 2-3 mbpd on a year-on-year basis, which should provide further support to oil prices and ease the pressure on inventory levels.

Where to go from here?

Oil demand should normalize in gasoline and diesel products by the end of this year, but full-year 2020 demand will still remain below previous year levels by 2-4 mbpd. Jet fuel demand is likely to stabilize much later and return to normal only at the end of 2022.

However, currently option prices continue to price in volatile swings in either direction, since high levels of uncertainty remain due to the unprecedented changes in demand, supply and inventories. Moreover, OPEC and Russia are likely to keep a lid on the rally if we do not see any significant production shut-ins by US shale producers. In fact, OPEC and Russia will do anything in their power to prevent oil prices from rising to levels that throw a lifeline to high-cost US shale producers. US shale producer shut-ins will only materialize if short dated prices remain below 30-35 US dollars and if longer dated prices do not rise above 40-45 US dollars. This means that OPEC compliance with production cuts could disappear if longer dated prices start to approach 40 to 45 US dollars in the coming months. These price levels are likely to be targeted by OPEC in 2021 when global oil inventories have come down significantly.

Significant upside for longer dated oil

Inventories are set to decline and the market is likely to be undersupplied in 2021. However, December 21 prices still do not reflect this as they are currently trading around 35 US dollars per barrel, which means that there should be significant upside potential for longer-dated prices. Even though the front end of the oil futures curve has demonstrated strength over the past week (rallying about 50% versus its April lows), trading the long end of the curve comes at much lower volatility and similar levels of upside compared to trading front-end contracts.