Why the Market Is Not Buying the Idea of a Big Rebound in Oil

Why the Market Is Not Buying the Idea of a Big Rebound in Oil

Reprinted from the FT – 09/07/2020

The outlook for demand seems very uncertain, once the pandemic finally slows, but betting on business travel quickly rebounding still seems optimistic. The oil industry has had a disastrous 2020, hit square-on by the full force of the coronavirus pandemic. From collapsing demand and the indignity of negative prices to a recovery that has been tepid at best, there are few smiles among executives in the sector today. Those who can manage a wry grin seem set on using the opportunity to write off billions of dollars from the value of their assets, resetting their businesses with one eye on accelerating the transition to cleaner fuels, as increasingly demanded by investors. But a few influential figures do believe there are better days ahead. The oil cycle, they argue, has not been broken yet. Low prices and under-investment in the sector could still lead to a runaway rally eventually, they say, once the dark days of lockdowns and insipid demand are a thing of the past.

Take JPMorgan. The bank’s lead oil equities analyst, Christyan Malek, says crude prices cannot remain depressed forever. While global oil demand is still down sharply from its pre-Covid level of 100m barrels a day, he sees the seeds being sown of “the next oil supercycle”. His view is predicated on the long-term hit to supply being larger than the long-term hit to demand. It will take until late 2021 for demand to return to pre-crisis levels, he says — in effect losing two years of growth, or 2m-3m b/d — but Mr. Malek sees a sharper fall in production along the way.

About 1m b/d have been wiped out by old fields being shut down that will not return even if prices rise, he argues. Another 4m b/d of supply will be lost from delayed or deferred investments in new projects and expansion plans. That suggests a supply gap could open from around 2022. “Covid-19 has increased the chances of much higher prices,” Mr. Malek says.

Oil majors face up to plunging asset values. It is a seductively simple argument and should play well with national oil companies such as Saudi Aramco (which JPMorgan advises) and US majors such as ExxonMobil and Chevron, which have been slower than European peers to make plans for the energy transition. And it may well be right.

Whether you believe peak demand is just over the horizon or not — most analysts still put it at some point in the 2030s, as electric vehicles achieve mass adoption — a supply gap for what remains of the world’s most important commodity should raise prices, and perhaps to a substantial degree.

In 2011 the loss of less than 2m b/d from Libya was enough to send prices to more than $120 a barrel, less than three years after the financial crisis. But the broader market does not appear to buy that argument just yet. Brent crude oil contracts for delivery three years from now are trading at less than $50 a barrel, barely $5 above the current spot price. That might present an opportunity. But it could also be a reason for caution. Though the oil market tends to move in cycles, it certainly does not move in circles, mirroring what has gone before.

Oil crash piles pressure on the bloated refining sector. Part of the argument for a noughties-style oil spike assumes that the US shale industry, where growth has done much to cool price rallies in recent years, will no longer be able to respond to market signals so quickly.

It is true that having frustrated investors and its financial backers on Wall Street, the shale sector is looking at a period of contraction followed by much slower growth. But the oil is still there. Companies know the rocks where it lies, and they know how to get at it. Any sharp rise in prices is going to be pushing up against that reality.

Another reason to be cautious is the very uncertain trajectory for consumption once the pandemic finally slows. Rising demand for jet fuel, which the industry was banking on for a large chunk of global growth in the coming years, still looks questionable.

Escapees from lockdown may be keen for a couple of weeks on sunny shores, but betting on business travel quickly rebounding still seems optimistic.

The ascendance of video conferencing as a day-to-day tool is likely to keep a lid on growth. The biggest challenge to the bulls, however, is what an oil spike might do to increase the speed of the transition to cleaner fuels.

A lot of progress has been made over the past five years when crude largely languished below $80 a barrel. The response to a sustained rally would be akin to crude signing its own death warrant.

So, one last hurrah? Perhaps. But it is likely to prove a short one.