Oil Price Faces More Downside Risk In The Near Future

Summary

• US gasoline demand recovery is unable to carry oil price recovery further. Refinery utilization rate and driving activity are ramping up enough.
• Looming oil supply comeback from OPEC+ and Libya, along with moderating US oil production decline could hinder the recovery.
• Investors should take hedges and protect profits amid the increasing uncertainty.

The US oil price experienced a considerable comeback in the second quarter, with the benchmark WTI nearly doubling from $20 at the end of March to the current ~$40. This recovery was driven by the substantial oil supply cuts from OPEC countries and their alliances (OPEC+) and faltering domestic US production amid low oil prices. This improved oil demand also helped the price recovery as well. 

Of these positive factors driving the recovery of the oil market, the story of supply side has been central to the narrative. The magnitude of production cuts from OPEC+ was unprecedented. The 9.7 mmbd production cut, nearly 10% of the total global production, dwarfs the prior production cut of 1.5 mmbd made by OPEC+ in 2016. With an even deeper cut, the rebounding oil price is unsurprising.

Now with the price being pushed higher by the initial deep production cut, the durability and magnitude of oil price recovery is in question. Recent oil price movement shows that the market is seeking new catalysts. However, recent market developments may signal that price recovery will likely be suspended or even face a setback. 

US oil demand recovery is unable to carry the oil price recovery further

The US domestic oil demand has fallen sharply since the nationwide lockdown. Gasoline demand, the biggest part of the overall oil demand, experienced the steepest decline, falling well below historical levels. Distillate and jet fuel demands are also negatively impacted by decreased economic activity and limited air travel.

As the lockdown is easing, the market is expecting a return in oil demands, especially in gasoline. Lower gasoline prices and preferences for driving over mass transportation and air travel are expected to further boost this year’s gasoline demand in the summer driving season. EIA’s weekly count for gasoline demand indicates a V-shaped recovery. 

figure 1 U.S. demand of oil products (gasoline, distillate and jet fuel)		Figure 2 U.S. weekly gasoline demand
Source: EIA Petroleum Supply Monthly, June 2020		Source: EIA

Despite the good news of gasoline demand recovery, it does not reveal a complete picture of the market. The inventory level of gasoline is still much higher than the 5-year level. Considering that the 5-year historical data include the data from oversupplied markets in 2016 and 2017, which are already well above the longer-term historical level, the 2020 gasoline inventory level is simply unprecedented. Over the past two months, the inventory level has stayed flat instead of falling in line with the seasonal pattern, with the worrisome suggestion that the summer driving demand isn’t mopping away enough inventories. Regarding the days of gasoline supply, the inventory level seems to fall faster but is still well above the normal summer level.

Figure 3 U.S. weekly gasoline inventory		Figure 4 U.S. weekly gasoline inventory in days of supply
Source: EIA		Source: EIA

The bloated gasoline inventory is also a headwind to the crude inventory. US refineries are recovering from the lockdown and ramping up summertime production. However, the pace of this increase in production is merely in line with the seasonal pattern, with no increased effort to make up for the loss of production. The current US refinery run rate is still ~4 mmbd below the 2019 level.

One reason for US refineries not working harder to compensate is that the current summer gasoline crack spread is not profitable enough. Despite improved profitability over the past few weeks, the overall profitability level is still below historical levels. Cheap gasoline prices and abundant gasoline inventory are pressuring refiners' margins, making them less incentivized to run at higher utilization rates.

Figure 5 U.S. refinery inputs (4- week avg.)		Figure 6 U.S. RBOB gasoline crack spread
Source: EIA		Source: CME Group

Without higher refinery inputs drawing crude inventory, the fast draw of US crude inventory is not shown by the EIA weekly inventory number. Considering the recent decline in domestic crude production and import, the recent weeks’ crude draws from the refinery input side maybe even less.  

Figure 7 U.S. weekly crude oil inventory		Figure 8 U.S. weekly crude inventory in days of supply
Source: EIA		Source: EIA
Figure 9 U.S. weekly domestic crude oil production		Figure 10 U.S. weekly crude oil imports
Source: EIA		Source: EIA

The high inventory level and slowing refinery ramping are hindering the chain effect from increasing driving activities to crude inventory draws. Investors can argue that while the driving activity level shows constant improvement, more crude is eventually needed to meet that demand. However, the alternative traffic data provided by Apple Map indicates that the recovery of driving activity is also in uncertainty now.

Apple Map is tracking the number of map-routing inquiries; the subsequent data shows a sudden decline in routing requests after the lockdown, in line with the levels of driving activity and gasoline demand. The data slowly improved after April as states gradually began to ease lockdown measures.

Now with the recent surges in COVID-19 cases, most of the affected states are rolling back their plans for re-opening. Of the states with the highest spikes in cases, California, Texas, and Florida happen to be the top three states with the biggest gasoline demands. Together with Arizona, these states comprise around one third of US gasoline demand. For these four states, the rise of routing request data seems to have already slowed after June, indicating the pace of driving activity and gasoline demand recovery to have plateaued. Going forward, if COVID-19 cannot be contained in these states, we could see the data to decrease again or, at best, remain flat. Either way, the recovery of gasoline demand in these states is in question.

Figure 11 Change in the number of routing requests in California		Figure 12 Change in the number of routing requests in Texas
Source: Apple map analytics		Source: Apple map analytics
Figure 13 Change in the number of routing requests in Florida		Figure 14 Change in the number of routing requests in Arizona
Source: Apple map analytics		Source: Apple map analytics

If driving activity does not increase, the associated gasoline demand growth will not be enough to clear the overhang of gasoline and crude inventory. With the demand outlook in question, rebalancing the oil market will take longer than a V-shape recovery.   

Looming oil supply comeback could hinder recovery

The supply side of the oil market is also showing troubling signs. The biggest unknown now is how OPEC+ will continue to cut production. OPEC+ is reported to have achieved a cut compliance rate of 107% in June; however, this could be the peak of the cut compliance. The rising oil price and continued free riding from non-compliant members are starting to disintegrate the alliance. Saudi Arabia has been vocal in their discontent over Angola and Nigeria, as neither country has met its production cut target, and is consequently threatening a possible price war. Russian Energy Minister Novak is reported to expect OPEC+ easing oil production cuts in August. A possible 2 mmbd cut ease is a large number to add to the market. 

Figure 15 Major OPEC+ countries that are not meeting their cut targets (May 2020)

Source: OPEC, IEA

The rationale behind the move to ease the cut is understandable. Most OPEC+ countries experienced substantial oil revenue loss from both low price and volumes cut, with consequent fiscal deficits. Besides, some of these countries, such as Russia, have also been hit hard by the COVID-19 and are facing economic hardship as a result. With oil markets showing signs of improving, most of these countries are eager to raise their oil revenues. It is not a question of “if” OPEC+ will reverse the course and add supply, but “when”. What was once the tailwind to the oil market rebalancing will soon become the headwind.  

Figure 16 Most of the OPEC+ countries’ fiscal breakeven oil prices are below current oil price level

Source: IMF, Reuters, EIA

Another looming supply side risk comes from Libya, whose production has fallen this year with oilfields and ports having been blocked due to domestic unrest. The production loss was estimated to be around 900 kbd since January. Now with negotiations between different tribes, the oilfield production is set to restart. The country’s largest field, El Sharara, has gradually resumed production and aims to reach a full capacity of 300 kbd in the next three months; more fields are under negotiation to restart. Libya’s production has fluctuated in the past years with the reopening of fields constantly going back and forth, making a full production reopening unlikely. However, even a partial reopening could add meaningful supply to the already bloated oil market.

Another concerning issue is the pace of decline in US production. After adjusting for the impact of the hurricane, the pace of US oil production decline over the past three weeks has shown moderation, with the latest week sequentially flattening, compared to prior weeks’ declines of 100 kbd or so.

Figure 17 The pace of U.S. domestic crude production decline is slowing down

Source: EIA

Though weekly numbers could contain noises, evidence for the decline moderation can also be found elsewhere. More shale companies are reported to restart production at certain wells, which makes economic sense considering the current $40 oil price. Primary Vision, a third-party industry consultancy and data company, has reported that the number of well-fracking workers has increased by 56% in the past five weeks. This shows that cash-strapped shale oil companies are starting to bring back the fracking crews to complete some drilled but yet producing wells. Completing these wells has the lowest need for cash investment to produce, which is the quickest way to boost oil output and cash income. These events signify that the largest part of US production reduction may have already occurred; going forward, the decline may slow down or even plateau. 

Conclusion 

The oil market has made a great comeback in the second quarter. However, flashing alerts from the sides of both supply and demand are showing headwinds for further recovery. The uncertainty in demand recovery and the possible reversal of production decline could hinder oil price recovery. Investors should start hedging and protecting profits amid the increasing uncertainty.