Oil Forecast October

This report aggregates research and analysis from BloombergNEF and the Bloomberg Terminal to anticipate world oil market trends.

Oil forecast: High inventory and low demand signal slow recovery

A Bloomberg Report

Introduction

Will the world see $60 oil again? The current outlook for oil is grim, with world inventories well above their 5-year average, and product demand well below pre-pandemic levels. Yet, if world oil demand recovers the way the International Energy Agency (IEA) envisions, we anticipates that prices could return to $60 before year-end 2021. However, oil prices can rise, a number of conditions need to be satisfied, including lower inventory levels and a reduction in OPEC’s spare production capacity.

This report aggregates research and analysis from BloombergNEF and the Bloomberg Terminal to anticipate world oil market trends and outline the necessary conditions for oil recovery.

After the price shock: What oil needs to rebound
Modeling near-term crude oil prices with inventory and OPEC spare capacity
Oil-product inventory suggests recovery could be a lengthy wait

After the price shock: What oil needs to rebound

Inventory-price correlation indicates U.S. crude oil stocks need to shrink to ~450 million barrels for $60 Brent

Source: IEA, BloombergNEF estimates, EIA. Note: model data set from 1Q 2012 to 2Q 2020. *3Q 2020 is quarter-to-date data as of September 17, 2020.

In general, commodity prices have an inverse relationship with inventory levels. Crude oil is no exception.
BloombergNEF created an oil price model using quarterly average U.S. commercial crude inventory data as the independent variable and quarterly average Dated Brent, the European crude benchmark for physical trades, as the dependent variable.
Ideally, we would use OECD crude inventory to estimate Brent prices. However, due to the time-lagged nature of OECD crude stocks data and the high degree of correlation between U.S. and OECD crude stocks, we are using U.S. commercial crude inventory as a proxy for OECD crude inventory.
Brent is a better benchmark for world oil prices and balances because WTI is based on Cushing Hub pricing, and the Cushing Hub has at times been infrastructure-constrained. Using Dated Brent in our model also generated slightly better results than WTI.

Between 2012 and 2Q 2020, there is a reasonable relationship between U.S. crude inventories and quarterly Dated Brent prices.

U.S. crude inventory now stands at 496 million barrels, as of September 11, while the 5-year average is 455 million barrels.
Our inventory-based model indicates that an inventory of around 450 million barrels would signal Dated Brent to trade closer to $60/bbl.

Actual Dated Brent prices for 3Q 2020 (quarter-to-date) is averaging above what our inventory-based model indicated (see green dot on chart). However, the difference is well within the historical margin of error. Moreover, if we average out 1Q 2020 to 3Q 2020, the modeled results of $43.57 is fairly close to the actual of $41.83.

China slowdown, global pandemic caused this historical relationship to break in the past

For reality check, we took a closer look at the historical quarters in which U.S. crude stocks were near 450 million barrels and checked the corresponding average Dated Brent prices.
Since 2012, Dated Brent often averaged slightly above $60 per barrel during these quarters.

There were two exceptions:

In 4Q 2015, Dated Brent averaged $42 and U.S. crude stocks stood at 454 million barrels. We attribute this to demand worries. The Chinese economy had slowed to a sub-7% rate growth rate year-on-year in 3Q 2015, something the world had not seen since the 2008 global recession. Investors were fearful that crude demand would slow along with China’s economy.
In 1Q 2020, Dated Brent prices also averaged well below what our inventory-based model suggests. This time, a Saudi-Russian crude price war and pandemic-led demand destruction devastated crude oil prices.

Note: It would be unrealistic to rely entirely on our inventory-based model to estimate Dated Brent prices. After all, crude oil is affected by other factors such as geopolitical events, expectations of world economy performance, investor sentiments, weather events, as well as other fundamental factors. This modeling effort is intended to help lend insight into how a high-frequency data point, namely storage, can provide a bellwether to broader market trends.

Modeling near-term crude oil prices with inventory and OPEC spare capacity

OPEC spare capacity has become correlated with oil prices in recent years

Another key indicator of market balance is spare capacity held by the Organization of the Petroleum Exporting Countries (OPEC). Although OPEC does not have an explicit definition of ‘spare capacity’, the U.S. Energy Information Administration defines spare capacity as “the volume of oil production that can be brought on-line within 30 days and sustained for at least 90 days”. We can calculate a rough approximation of this using Bloomberg estimates for OPEC production and capacity.
Historically, the relationship between OPEC spare capacity and Dated Brent prices was statistically insignificant. However, it has improved since the start of 2018, which coincided with the rapid rise of U.S. crude exports. As more U.S. crude reached world markets, OPEC’s active management of its production has been its primary mechanism for balancing global markets and sustaining oil prices. OPEC’s withholding of production translates into higher spare capacity, and thus, spare capacity can be used as a proxy to gauge the oil market balance.

On the other hand, when the market is loose and supply is outpacing demand, OPEC often reduces output to balance the market, which leads to higher spare capacity. Therefore: loose market balance (and weaker oil prices). OPEC responds by reducing output, which leads to higher spare capacity.
During periods of market tightness when demand is outpacing supply, OPEC can increase production by tapping its spare capacity. Therefore: tight market conditions (and along with stronger oil prices). OPEC responds by increasing output and spare capacity falls.

OPEC spare supply capacity correlation also indicates big cuts needed for $60 Brent

BloombergNEF created another model, this time using OPEC’s spare capacity, and we tested two versions: One is based on total OPEC spare capacity using the Bloomberg terminal’s spare capacity ticker, which estimates August 2020 OPEC spare capacity at 10.2m b/d. The second version excluded Venezuela and Iran’s spare capacity, thereby reducing OPEC’s August 2020 spare capacity to 7.4m b/d.
In both, using the prior quarter’s Dated Brent prices improves the model. This implies that spare capacity lags prices, but in reality OPEC is just responding to market conditions, although on a time-lagged basis. It is also possible that OPEC often signals its production plans ahead of time, and these forward expectations get incorporated into commodity prices prior to the actual change in output.
The first model has an R2 of 0.87, and based on this correlation, Dated Brent is unlikely to reach the $60 range until spare capacity falls to 5.5m b/d, a 4.6 m b/d reduction from current levels. Excluding Venezuela and Iran further improves the model, resulting in anR2of 0.93. In this case, spare capacity needs to contract by 3.8m b/d to signal $60 Brent.

Oil-product inventory suggests recovery could be a lengthy wait

This analysis is by Bloomberg Intelligence senior industry analyst Henik Fung.

Rising oil-product inventories signal lasting energy demand weakness, which may keep a $40 lid on the oil price. A synchronized jump in road-fuel inventories in major markets could suggest that a demand uptick after June driven by restocking activities may have run its course, evident in Asia’s sub-zero refining margin.

Asia’s refining margins under water on demand, exports

Singapore’s complex refining margin may continue to languish below zero after falling to minus 38 cents a barrel on Sep. 11 vs. a $4.13 rolling five-year average. The negative margin has persisted since May when WTI led the way lower, as Asia’s gasoline and diesel demand remained sluggish, evident in China’s increased exports of transportation fuels. While the hit to consumption may not be as severe as in March, our analysis suggests net incremental oil-product supply of at least 2.5 million barrels per day (mmbpd) in 2H, and 4.2 mmbpd in 2021. A renewed COVID-19 threat may worsen the supply-demand gap, rendering a full recovery elusive.

Soaring crude, product inventories hint at demand weakness

Optimism over recovering oil demand has fuelled a WTI’s price rally to the $40 level. Yet a buildup of global inventory suggests demand remains sluggish, rendering a sustainable oil-price rebound far-reaching. The U.S. Department of Energy indicates crude inventory rose by 2 million barrels to 500 million barrels in the week of Sept. 4, reversing the downtrend since July. China’s August gasoline and diesel inventories at independent refineries were 13 million barrels, 11% higher vs. July. Without a steep pick-up in demand, oil and oil-product inventories may keep swelling, pressuring the crude price.

Crude spot prices reflect inventory drawdown

Short-dated oil futures are better proxies than spot for short-term market-price shifts, in our view, as traders tend to use them to capture price volatility. Our price-inventory model suggests WTI crude futures would have traded at the spot price of $37.33 on Sept. 11 if U.S. comparative inventory — crude oil, gasoline and diesel — had fallen to 830 million barrels from 900 million barrels. This implies the market expects oil supply and demand to balance out by end-2020, with inventory shrinking by 65 million barrels. Global demand can recover, in our view, yet it may not be enough to fully absorb inventory. A revival in shale-oil production, escalating U.S.-China tensions and a potential second wave of the pandemic could hamper a crude-price rebound.