Oil Steady As OPEC Eases Cuts

July 17, 2020

Oil prices held steady this week, even as the Organization of the Petroleum Exporting Countries (OPEC) and its allies signaled that they would pare some of their output cuts starting next month. Prices for West Texas Intermediate (WTI) crude oil were last trading at $41, close to the highest levels since early March.

WTI Crude Oil Prices

Actual Increase Foggy

The group known as OPEC+, which includes OPEC members like Saudi Arabia and Iraq, as well as nonmembers like Russia and Mexico, will increase its output by upward of 2 million barrels per day in August.

The dramatic output curbs put in place in April, when oil prices briefly fell into negative territory, were equal to 10% of global supply. Those cuts, which currently stand at 9.7 million barrels per day, may be eased to 7.7 million barrels per day next month.

However, the actual increase in production may be less than the 2 million barrels per day suggested, because some countries that didn’t fully adhere to the original agreement—such as Iraq, Nigeria and Russia—will have to make up for their shortfalls in the coming months. Therefore, actual cuts in August may be more than 8.1 million barrels per day, according to Saudi Arabia’s energy minister.

Still, that means in about two weeks, output should increase by nearly 1.5 million barrels per day, reflecting the group’s confidence that the oil market can absorb more supply despite ongoing economic weakness around the world.

Better Than Feared

The oil market has come a long way from its darkest hours in March and April. Back then, demand was expected to completely collapse and storage was forecast to overflow with crude. (Read: Stunningly, Oil Prices Crash Below Zero)

Those most dire predictions never materialized, partly because demand rebounded faster than expected, and partly because the global supply response has been so great.

In April, the International Energy Agency (IEA) forecast that demand in the second quarter would plummet by 23.1 million barrels per day. This month, the IEA said that its previous projection had been too grim; demand in Q2 actually fell by 16.4 million barrels per day, an improvement of nearly 6.5 million barrels per day.

Demand Future Brightens

In the second half of the year, the IEA now expects demand to be down by 5.1 million barrels per day from a year ago, better than the 10.75 million barrel per day decline in the first half of the year.

Meanwhile, the IEA said that supply has fallen by more than expected this year. In addition to steep OPEC cuts, production declines in the U.S., Canada and elsewhere combined to send global supply down by 14 million barrels per day between April and June.

If sustained, that would dwarf the demand decline that the agency forecasts for the second half. But of course, OPEC is already starting to open up its oil taps a bit, and even U.S. producers are bringing some shuttered wells back online.

U.S. crude oil production peaked at 13.1 million barrels per day in March, tumbled as low as 10.5 million barrels per day in June, and currently stands at 11 million barrels per day.

US Crude Oil Production

 

New Oil Investment Bearish

Longer term, traders will be looking to see how supply fares in an environment of severely reduced investment in new oil wells. According to an analysis by Rystad Energy, global capital expenditures by exploration and production firms may drop by $100 billion, or 17%, this year. That could hurt future supply as old oil wells dry up and new wells aren’t there to replace them.

On the other hand, at least initially, there is a lot of spare capacity in the system—including the 9.7 million barrels per day (soon to be 7.7 million barrels per day) of OPEC+ production that has been curtailed.

At the same time, on the demand side, there is some debate about whether consumption has been permanently altered in the post-COVID world. Jet fuel demand may stay depressed for a while as people remain reluctant to travel. Then there is the impact that the shift to work-from-home will have on gasoline and diesel demand to consider—not to mention the secular shift from internal combustion engine vehicles to electric vehicles, which may further dampen oil demand.

ETF Choices, How Futures Work

Investors interested in gaining exposure to the oil patch have many ETF options. The largest oil-tracking ETF, the $4.4 billion United States Oil Fund LP (USO), now holds multiple oil futures contracts across the curve, shifting gears from being exclusively focused on the front month. (Read: Biggest Oil ETF Shakes Up Structure)

The fund has gained 72% from its lows in April, but is still down 71% on a year-to-date basis. Roll costs—or the cost of rolling from cheaper futures contracts to later-dated, more expensive futures contracts—have taken a steep toll on returns for the ETF this year.

The chart below shows the current state of the futures curve, which is still in contango (where later-dated contracts are increasingly expensive), but the incline is much less pronounced than it was a few months ago. That means roll costs are more modest today. 

Meanwhile, one of USO’s competitors, the $464 million Invesco DB Oil Fund (DBO), hasn’t had the roll cost drag that the former has thanks to its singular focus on the February 2021 oil futures contract. The ETF rallied 40% since its April lows and is down 31.6% on a year-to-date basis.

Energy equity ETFs are also an option for slightly more indirect exposure to oil prices. The $10 billion Energy Select Sector SPDR Fund (XLE) has rallied 58.6% off its March lows and is lower by 35.4% on a year-to-date basis.

Finally, another fund to consider is the VanEck Vectors Oil Refiners ETF (CRAK), which holds stocks of companies that turn raw crude oil into petroleum products. It’s climbed 52.2% since the March lows and is down 24.6% year to date.

Email Sumit Roy at [email protected] or follow him on Twitter @sumitroy2

 

 

 

 

 

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