The Fragility of the Oil Price Rally

INFOCUS MACRO COMMENT

MARCH 2021

The fragility of the oil price rally

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Oil prices have returned to the levels of a year ago, a surprising development given the incomplete recovery of the global economy from the pandemic. In this edition of Infocus, GianLuigi Mandruzzato looks at the fundamentals of the oil market and concludes that the risks to the oil price are predominantly to the downside.

Oil prices have risen by more than 70% since the US 2. OECD petroleum stocks presidential election in early November. Many commentators 4800 130 explain the rally by the combination of a slim Democrat majority in the US Senate and confidence about the impact 4600 120 of Covid vaccines, which are expected to boost the chance of 4400 110 further fiscal stimulus and economic recovery. Supporting the rise in oil prices is the fact that US demand for oil products 4200 100 has almost returned to pre-pandemic levels while US oil

Million barrels 4000 90 production has fallen by over 2 million barrels per day (mbd) Days of OECD demand (see Figure 1). In addition, Saudi Arabia unilaterally reduced 3800 80 production by a further 1mbd for the February-March period. Forecast 3600 70 Finally, the freezing weather conditions recently registered 2000 02 04 06 08 10 12 14 16 18 20 22 in the US, including Texas, have both increased demand for Petroleum total stocks Days of OECD demand (rh axis) heating oil and temporarily reduced US oil production by an Source: IAE, Bloomberg and EFGAM calculations. Data as at 25 February 2021. estimated 2 to 4mbd. Lehman Brothers in 2008-09 and after OPEC’s decision to flood 1. US oil demand and output the market in 2015-16, which caused the price of West Texas Intermediate (WTI) oil to fall towards USD 25/bbl. According 22 18 to our estimates based on International Energy Agency 21 16 (IEA) projections for oil demand and supply, the stocks-to-

20 14 e ge

ag consumption ratio will fall in the coming quarters but at the 19 12 er end of 2022 it will still be similar to the previous peak reached 18 10 in early 2016.

17 8 Mbd, 4-week av Mbd, 4-week ave ra 16 6 The slow decline in the stocks-to-consumption ratio reflects a deterioration in forecasts of future demand and estimates of 15 4 OPEC production needed to balance oil demand and supply, 14 2 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 a measure known as call-on-OPEC (see Figure 3). In the latest US oil demand US oil output (rh axis) edition of its monthly Oil Market Report, the IEA reduced its Source: EIA, Reﬁnitv and EFGAM calculations. Data as at 25 February 2021. estimate of 2021 oil demand by about 0.7 mbd from the level

The market remains well supplied 3. Oil demand and call-on-OPEC forecasts

This would suggest a tight oil market, with relatively little 100 34 production to meet demand. Excess demand has been 98 32 satisfied by drawing on the abundant stocks of oil products

y 96 30 y that were accumulated during last year’s lockdowns. Despite 94 28 recent drawdowns, data from the US Energy Information 92 26 Administration (EIA) show that inventories are still close to all- 90 24 time highs, both in absolute terms and, more importantly, in 88 22 Million barrels per da relation to demand for oil products (see Figure 2). Million barrels per da 86 20

84 18 The ratio of stocks to consumption is one of the most 82 16 informative measures of the availability of petroleum Mar-20 Jun-20 Sep-20 Dec-20 Mar-21 Jun-21 Sep-21 Dec-21 Mar-22 Demand: (lh axis) Call-on-OPEC: (rh axis) products. Its rapid rise is usually associated with downward Feb-21 Nov-20 Feb-21 Nov-20 pressure on oil prices, as happened after the collapse of Source: IAE, Bloomberg and EFGAM calculations. Data as at 25 February 2021.

2 | March 2021 THE FRAGILITY OF THE OIL PRICE RALLY

expected in November. The call-on-OPEC estimate fell by 0.9 5. WTI price and model forecast mbd, the larger reduction reflecting increased expectations for 110 production from non-OPEC countries. Saudi Arabia’s decision 100 to temporarily reduce production can therefore be seen as 90 intended to avoid a new drop in prices rather than a move 80 aimed at raising them. 70

Is the price right? USD per barrel 50 It is therefore difficult to explain the recent strong rally in oil 40 prices. In thinking about the degree of market exuberance, it 30 is helpful to estimate a regression model that explains the 20 price of WTI oil as a function of oil supply and demand, the 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 WTI price WTI price forecast 95% conﬁdence range ratio of stocks to consumption and the US dollar effective WTI futures prices as at 25 February 2021 exchange rate (see Figure 4). The model’s residuals support the Source: Reﬁnitiv and EFGAM calculations. Data as at 25 February 2021. hypothesis that the variables are cointegrated and suggests that if the price of WTI oil moves away from the estimated forecast. This suggests that the market is currently discounting equilibrium values, it subsequently tends to converge back a rather benign scenario where prices are supported by a mix towards them. of higher demand, perhaps because of a stronger economic recovery, and lower supply of oil products than projected by 4. WTI price and fair value estimates the IEA.

150 125 The alternatives for OPEC+ 120 100 This optimistic scenario will be put to the test at the OPEC+ 90 75 meeting scheduled on 4 March.3 The market seems to be USD per barr

60 50 expecting a price-friendly decision, such as a reduction in % production or an extended commitment not to increase it. 30 25 el 0 0 However, this may be insufficient to prevent an increase in oil

-30 -25 supply. According to the Kansas City Fed’s quarterly survey, the price of WTI is now higher than US shale oil producers need -60 -50 86 89 92 95 98 01 04 07 10 13 16 19 22 to be profitable and to encourage a substantial increase in WTI fair value gap WTI price (rh axis) +/-1 standard deviation Fair value estimates (rh axis) drilling and output (see Figure 6). Source: Reﬁnitiv and EFGAM calculations. Data as at 25 February 2021. 6. US shale producers’ threshold prices and WTI According to the model, the current price, of about USD 63/bbl 80 at the time of writing this note, is more than 50% higher than the equilibrium price, suggesting that risks to future oil prices 70 are predominantly to the downside. 60

Extending the analysis, it is possible to forecast the future 50 price of WTI oil using a model that expresses the changes

USD per barrel 40 in the oil price as a function of changes in the explanatory 2 variables used in the previous model (see Figure 5). Based 30 on the IEA’s oil supply and demand projections, the model 20 predicts that the price of crude oil will fall towards USD 40/bbl. 2015 2016 2017 2018 2019 2020 Proﬁtable oil price WTI oil price, quarterly average It is also interesting to note that, at the time of writing this Price to substantially increase drilling note, the prices of WTI oil futures contracts lie above the upper Source: Kansas City Fed and Reﬁnitiv. Data as at 25 February 2021. end of the 95% confidence range around the model central

1 The model uses the logarithm of the levels of quarterly data for the period from 1986 to the first quarter of 2021 2 The variables in the model are expressed as logarithm changes of quarterly data. The WTI oil price is the dependent variable and the explanatory variables are the same as in the levels cointegrating model. In addition, the 1-quarter lagged residuals from the cointegrating model is added in the dynamic model. 3 OPEC+, formed in December 2016, includes the OPEC countries, Russia, Mexico and some other oil-producing countries, but not the US.

March 2021 | 3 THE FRAGILITY OF THE OIL PRICE RALLY

The next OPEC+ decision on production levels will be not be Conclusions easy. Further limiting production would support prices to The sharp rise in oil prices in recent months has surprised the benefit of member countries’ public finances, which are many observers and would suggest an excess of demand heavily dependent on oil-related revenues. However, it would over supply. However, inventories remain high when subsidise the profitability of other producers who would also compared to current demand while balancing the physical gain market share. This last element might be difficult for market seems possible with less OPEC supply than expected OPEC+ to accept: in December 2016, its members controlled a few months ago. 58% of world oil production, but their share has since fallen to less than 50%. The long-term relationship between the oil price, supply and demand and the ratio of stocks to petroleum products If OPEC+ prioritises market share over price support, the consumption suggests that the price of WTI of around increased oil supply would likely cause prices to fall. Although USD 63/bbl is too high. Perhaps the market expects OPEC+ not ideal, this scenario could still be accepted by Saudi Arabia members, led by Saudi Arabia and Russia, to extend current and Russia, the most influential countries in OPEC+, which price-supporting policies at their meeting in early March. together extract 20 mbd and have a combined spare capacity Should they instead prioritise their market shares, the price of around 5 mbd. In both countries, the cost of producing a trend could quickly turn downwards. barrel of oil is much lower than prices needed by US shale oil producers to cover their costs. In December 2019, IHS Markit estimated the total cost of producing a barrel of oil was around USD 17/bbl in Saudi Arabia. The estimate for Russia was around USD 43/bbl but, as Russian production costs are predominantly denominated in local currency, the 15% depreciation in the rouble against the US dollar since then will have likely pushed Russia’s oil break-even cost below USD 37/bbl. This leaves ample room for Saudi Arabia and Russia to weather a period of significantly lower prices without suffering significant setbacks.

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