Oil Market Recovery and the Balance of Risks
While the market is shifting its attention to OPEC+ dynamics and the return of Libyan and Iranian barrels, the reality remains that this is first and foremost a demand shock and ultimately the evolution of demand will be the key factor shaping oil market outcomes. This demand shock is special in many ways compared to previous shocks: in addition to its size and the speed at which global oil demand contracted, its impact has been highly uneven across geographies (Asia versus the rest of the world) and across fuels (jet fuel and distillate demand versus other parts of the barrel). This has created a challenge for refineries and their margins have been under severe pressure. The combination of OPEC+ cuts and the return of Libyan barrels have created unevenness in terms of crude quality, with light sweet crudes in abundant supply compared to heavy-medium and sour crudes. The size of the shock and the unevenness of its impacts imply a recovery process which is far from smooth.
As the OPEC+ meeting approaches, all eyes are on the Group’s next move. The main choices facing OPEC+ are taper the cut as planned, extend the current cut (and its duration) by deferring the taper, or deepen the cut. Ultimately, the effectiveness of the OPEC+ response will be shaped by demand conditions. Our results show that by extending the current cut for 3 months under reference growth, OPEC+ will be able to keep oil prices well supported in the $40/b-$45/b price range in H1 2021, lifting the Brent price by nearly $4/b on average compared to our base case of no extension and by $2/b for 2021 overall. What is interesting is that in both scenarios (tapering the cut or extending the cut for 3 months), market deficits persist throughout our outlook (barring a rapid deterioration in global oil demand including Asian oil demand). A shift in expectations of improved fundamentals in the second half of 2021 following the positive news on the vaccine may render the option of withholding barrels today and releasing them when the better times arrive attractive. If demand recovers quicker than expected due to the wide availability of an effective vaccine, the oil price is projected to increase moderately up to $4/b annually under the extension scenario as any rally will still be capped by existing buffers of inventory. In the less likely scenario that OPEC+ decides to deepen the cut by 1.9 mb/d, essentially returning to the first phase of the agreement, the price would break the $50/b mark and average $52.9/b in Q1 2021, again assuming that demand does not suffer from a new virus-induced shock. However, there is a fundamental trade-off with this option, as deeper cuts increase the risk of non-compliance. Our results show that if compliance deteriorates the oil prices in 2021 could lose as much as $7/b on annual terms, compared to our scenario of full compliance. Thus, whatever decision OPEC+ takes, maintaining high compliance is key.