2020 will be remembered not just for the COVID-19 pandemic, but for the launch of an oil price war and the subsequent oil price collapse. In this report, J.P. Morgan Research takes a look at global oil demand, the impact of supply cuts and the technical drivers behind the difference in price between the two major oil benchmarks, West Texas Intermediate (WTI) and Brent Crude.
With over 80% of the world’s working population under some form of lockdown during the month of April, the shock to global oil demand was unprecedented.
The combination of record inventory builds, a severe storage shortage and sinking demand due to the COVID-19 pandemic culminated with U.S. crude oil futures (WTI) crashing into negative territory on April 20 for the first time in history.
Oil demand around the world plummeted to around 73.1 million barrels a day (mbd) in April, a staggering 26.2 mbd lower than a year earlier—a figure close to 87% of oil producing union, Organization of the Petroleum Exporting Countries, and its allies (OPEC+’s) current production level of around 30 mbd.
As prices hit a low of $25.57 for Brent and negative $37.63 for WTI on April 20, fear has been a great uniter. OPEC+ countries have put in motion a cumulative total of 10.9 mbd of production cuts since the April OPEC+ meeting. No additional cuts are expected to be announced at the June 10 virtual meeting, given that certain members have already announced additional cuts for June in May.
As well as deep production cuts from OPEC+, the magnitude of the price cut has finally drawn in substantial participation from North American producers, even if only through organic production declines. The count of U.S. rigs drilling for oil and gas has hit its lowest level since at least 1985 at 374 as of May 8.
The price differential between WTI and Brent reached a peak of $63.20 per barrel before recovering throughout May due to production cuts and an ease in lockdown with the gap closing to trade around $1.50.
While there is still a massive glut of oil that will need to be cleared before there can be any meaningful recovery in prices, we believe that the global oil market is tentatively entering an inflection phase.
The OPEC+ cuts sets the stage for a stronger second half of the year as surpluses turn to deficits in the third quarter, inducing inventory draws. The world’s crude oil supply is set to decline by 11.4 mbd in June compared to the peak production in January, but the first month of actual deficit is expected to be in August. By July, J.P. Morgan’s Commodities Research team forecasts around 2.5 mbd of declines in total liquids supplied in the U.S. from its high in February, which should eventually reverse the build-up in Cushing, Oklahoma inventories, the largest oil-storage tank farm in the world, sometime in mid-July.
“While there is still a massive glut of oil that will need to be cleared before there can be any meaningful recovery in prices, we believe that the global oil market is tentatively entering an inflection phase where rebalancing has started and expect supply to finally equal demand by July to early August,” said Natasha Kaneva, Head of Commodities Research at J.P. Morgan.
“We believe that the two major oil benchmarks, WTI and Brent Crude, will trade at parity at $34 per barrel toward year-end 2020,” added Kaneva.
By the end of 2020, J.P. Morgan Research predicts global oil demand will average 90.4 mbd, a loss of 9.4. mbd compared to 2019. Although signs of recovery in physical oil markets are emerging and supply is finally responding, the fall-out from COVID-19 will be lasting. The damage to global oil markets will persist into next year, and Brent is forecast to average $37 per barrel for 2021. There is a growing risk that the demand side will not be able to recover to pre-crisis levels as global capital expenditure is cut dramatically.
“Demand will likely only reach a pre-virus run-rate in November 2021. Aviation demand in particular will be slow to recoup losses,” said Joyce Chang, J.P. Morgan Chair of Global Research.
“In our view, natural gas is the obvious winner as widespread oil curtailments lead to a tight natural gas market, and we anticipate that the 2021 futures strip will need to rise to levels to motivate gas producers to add supply or drive demand destruction (i.e., gas to coal switching),” added Shikha Chaturvedi, Senior Commodities Strategist at J.P. Morgan.
The severity of the oil market correction will also have long-term implications for the U.S. high yield energy market. The risk premium to own oil and gas assets has likely been permanently increased due to the compound effect of greater uncertainty on supply and demand and lower bounds on price. Energy remains a decent share of U.S. High Grade and High Yield Credit indices, accounting for around 8-9% in J.P. Morgan’s high yield indices.
High grade credit has seen the fastest pace of downgrades year-to-date since 2007. In the first four months of 2020, there were 36 fallen angels, or companies that lose their investment-grade rating and are downgraded into junk territory globally, totaling $167.6 billion. Some $160.8 billion of these fallen angels were U.S. based. This already accounts for the largest annual total in the market’s history both globally and in the U.S.
“We now project another $40-50 billion of fallen angels and a 43% cumulative default rate over the next three years for the U.S. high yield energy sector,” said Tarek Hamid, Head of North American High Yield Energy Credit Research.
Overall high yield default activity surged in April, with a record 19 companies filing for bankruptcy or missing an interest payment. U.S. high yield defaults are running at a 10-year high of 4.92%.
The J.P. Morgan U.S. High Yield Strategy team forecasts this to reach 8% this year. However, if the virus continues to keep parts of the U.S. economy closed longer than currently expected, the U.S. high yield default rate could surpass 10% by year-end and possibly approach 15% in 12 months, depending on the extent of additional impacts to the U.S. economy.
In contrast to the high yield credit market, equity markets are positively decoupling to crude prices on the prospect of a healthier oil market and a new upcycle from 2022 if demand recovers and supply rolls.
The combination of a breathtaking reduction in U.S. shale activity, capital expenditure curtailments by the international oil companies and pressured Gulf Cooperation Council fiscal budgets suggests deeper OPEC cuts are increasingly likely (instigated by Saudi Arabia, which has announced an additional output reduction to 7.5mbd in June), further supporting medium-term market dynamics.
“Indeed with Saudi’s war of pain thresholds stabilizing, the risk/reward for oil equities screens as attractive at current valuations, although dividend coverage remains the ‘monkey on the back’ for management teams and investors’ key focus following the first quarter reporting season” said Christyan Malek, Head of EMEA Oil and Gas Equity Research at J.P. Morgan.
The exploration and production sector is largely uninvestable for the intermediate term as oil prices have fallen below marginal shale economics. Commodity currencies remain vulnerable, particularly the Canadian dollar, since it is the highest cost producer and also suffers from a weak balance of payments.
However, the impact across other asset classes has been contained and what is occurring outside of crude in global markets looks tame by the standards of typical corrections during a recession. Energy is also a much smaller share of the market relative to its share during the 2008 global financial crisis, accounting for only 3% of the S&P500, implying less scope for any earnings downgrades to influence the broader market materially.
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