- Markets are overreacting to the current outbreak of coronavirus. Fundamentals suggest that China's oil consumption still remains robust and can recover quickly.
- Fed says that it will act appropriately and Saudi Arabia is planning to cut 1 million barrels per day. The virus itself seems to be under control in China.
- There are other indicators as well that show economic activity is recovering. We might see oil prices start to rise again.
- The psychological barrier of $40 seems a strong one and a nice area to go long on WTI for an upside of $3-$4.
Oil prices, in less than 2 months, have faced some serious volatility. First a geopolitical flash point was triggered in January 2020 and global crude prices touched $70 and $65 -- Brent and WTI respectively. After that a deadly pathogen known as Novel coronavirus (initially nCov-19 and recently COVID-19) shook the whole world with global financial and commodity markets cratering to an extremely bearish territory. The U.S. stocks have already entered into a correction (a 10 percent drop from recent highs) and oil markets are panicking with WTI now trading at $45.25 (at the time of writing).
Against this bearish background, a valid and highly significant question is how low can the prices go? As simple as it sounds; one cannot answer it exactly however, we can try to track the trajectory in the coming days based on a few fundamentals and lots of sentiment.
The meaning of the phrase ‘If China sneezes, the world catch a cold’ couldn’t be clearer lately. China contributes more than 17 percent to the global GDP. It is the most important node in the nexus of global value chains. It makes 70 percent of the world's air conditioners, 58 percent of shoes and Chinese overseas have spent about $277 bn in 2018 - one fifth of global spending. China also accounts for 13 percent of global crude oil demand.
With this in mind, it is natural that a virus with its epicenter in China (Wuhan, Hubei province) can inject real fears of a recession -- shadowing the fundamentals. Let’s talk about China’s oil demand. Whereas slow growth in oil isn’t a new phenomenon, this year the IEA has slashed its growth forecast for first quarter of 2020 by 435,000 bpd. The total anticipated demand has been slashed by 365,000 bpd to 835, 000 bpd for the year 2020.
But it is not all gloom and doom. First, the spread of coronavirus in China is slowing down. Statistics regarding consumption of coals, traffic movement and sales of property have shown some upticks. The Chinese stock market, that fell more than 10 percent at the outset of the virus, has almost recovered. China has also promised to unleash a huge monetary stimulus ($157 bn). Analysts predict that China will be back to business by end of March.
Then there is the country’s oil consumption. We have to differentiate between the domestic fuel consumption and the overall oil demand. The refiners are still exporting healthy volumes of refined products and the country is still filling the strategic reserves. According to Refinitiv Oil Research oil imports in China will drop to 10.53 mbpd in February as compared to 10.69 mbpd last month -- a drop of 160, 000 bpd. Different estimates suggest that China’s oil imports may start to improve from April.
Also, we have news that Saudi Arabia is planning for a production cut of 1 million barrels per day. If this happens then that will bring the total cuts to 3.1 mbpd -- the highest since the 2008 Western financial crisis. Russia has hinted at agreement with the cuts- the reason for the recent rally.
We can also look to West Africa for China’s oil demand -- the region is responsible for one-fifth of China’s oil imports. Albeit, there has been a relative slowdown in cargoes to China few suppliers said that the demand is recovering from the initial steep downward trend seen at the start of the outbreak.
Not lower than 40
Now comes the question should we short or go long? To answer this we need to know how low the oil prices can go. Brent has already dropped below the support level of $50 and WTI went down all the way to $43.89 Friday night -- both have recovered from these levels. I posit the following approach to take advantage of this range-bound activity: that prices will start to retrace after hitting a strong support level of $42 (last year’s low). We might see panic selling and prices touching the psychological barrier of $40 (the ticker may blip to $39) but hold strong whenever you get this chance .
In the coming days, I expect to see the fear converting into calm. Fed has said that it will “act appropriately” and has cut interest rates as many were expecting. If Russia really participates as it has hinted (even though temporarily), we might see a short spike in prices -- that will be the window to cover your positions.
Traders might want to start buying WTI when we see a level of $43 and below with a profit target of $3-$4.
In case you want to go short, $49 - $51 is the level to look for. The recent rally, which appears to be a "dead cat bounce", will not be sustainable. So you can go short from here until $44-$42. Another reason to short oil at this point would be the ambiguity regarding the exact figure of production cuts at OPEC+ meeting. They have framed it against 1 million bpd -- anything less than that can hurt these expectations and trigger another sell-off.
Overall, the reason for a range-bound market remains the same: a drop in demand. In 2019, oil and gas recoveries reached four year-highs, but then the trade war put downward pressure on prices and now coronavirus continues this pattern. We will likely see (and I will write about it too) that the issue of a trade war will resurface to cause another sell-off in global commodity and stock markets. For now, enjoy the range-bound fluctuations.
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