After the Initial Oil Rebound: What Next for Market Fundamentals and Prices?
Following the sharp recovery in the oil price, which saw Brent increase by more than $16/b during the months of May and June 2020, the Brent price has been stuck in the narrow $40/b-$45/b range since July and despite the heightened uncertainty, volatility has been exceptionally low. On the one hand, this reflects the fact that the recent price recovery was driven by improved market fundamentals both on the demand and the supply side and hence the current price range is well supported. On the other hand, the narrow price range and low volatility reflect a market that is not yet ready to move to a higher price range as the V-shaped recovery in demand seems to have now stalled as concerns over the recent resurgence in Covid-19 cases have resurfaced in many parts of the world.
Given the wide uncertainty surrounding the medium and long-run prospects of oil demand and the slowdown in the momentum behind short-term oil demand, the role of the supply side in supporting the oil price becomes even more important in the current context. The historic OPEC+ agreement in April to cut output has been the key factor shaping the supply side. But the historic size of the cut would not have had its desired impact on prices and balances without the high compliance shown by OPEC+ (in the first phase of the agreement between May and July, OPEC+ producers achieved a high compliance rate of 97%). Achieving such high compliance without accounting for losses due to geopolitical disruptions and without GCC3 (Saudi Arabia, UAE and Kuwait) cutting above their quota and thus compensating for the rest of OPEC+ non-compliance has been a key feature of the recovery phase so far. This success could be attributed to Saudi Arabia’s clear signal that it will not tolerate any non-compliance as the cost of Saudi Arabia achieving full compliance on its own while the rest not fully complying is high enough to induce a shift in its output policy. The break-up of the OPEC+ agreement in March showed in a dramatic way that without a collective action on cuts, Saudi Arabia is willing to shift oil policy until players are ready to enter into an agreement. Once the agreement has been reached, Saudi Arabia offered to cut additional 1 mb/d in June, but this additional cut was temporary and limited in duration to one month and in July Saudi Arabia restored its output to the agreed quota level signaling that these additional measures should not be considered as permanent or be counted on to balance the market as was the case previously. The monthly meetings of the JMMC and the introduction of the compensation regimes are additional signals of the importance that Saudi Arabia attaches to compliance and its determination to lead on this front.
Looking ahead, the pace of demand recovery and OPEC+ responses are the key dynamics that would shape market outcomes and will determine in which direction and how fast the oil price will break away from the current range. Our model indicates that the breakout will occur in Q4, but it will be gradual and limited on the upside. Also, the market seems more prepared to move to a higher rather than to a lower price range and has been waiting for some positive signals on the demand side, particularly from the US and India. A key reason for this ‘upward’ bias is that there is a belief that generalised lockdowns similar to what we have seen in March and April are not likely and therefore demand will recover even though at a slower pace. In the background, the view that the oil industry cannot increase investment and bring new supplies in this price environment and it will take time for US shale output to recover to its previous peak are also gaining traction. Also, the market has a pessimistic view on the return of some of the disrupted supplies from countries such as Iran, Venezuela and even Libya. But a key premise underlying the upward bias is that OPEC+ cohesiveness and high compliance will be maintained, and this represents a fundamental shift from previous cycles.