Oil market tightens but COVID-19 could spoil the rally

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Global oil demand has rebounded somewhat faster than previously thought, although the spread of the corona virus in the United States and Latin America is “casting a shadow over the outlook,” the International Energy Agency (IEA) wrote in its latest Oil Market Report.

The last few weeks have seen crude oil prices trade in a “remarkably stable” trading range, and according to the futures market, traders anticipate that the historic surplus seen in the second quarter will give way to a deficit in the second half of the year.

Global oil demand declined by 10.75 million barrels per day (mb/d) in the second quarter, the IEA confirmed. That should improve to down only 5.1 mb/d in the second half of the year as large parts of the globe bounce back from lock downs. In fact, the IEA revised up its forecast for full-year demand to 92.1 mb/d, which is roughly 0.4 mb/d higher than last month’s report.

The reason? The sharp drop in demand during the second quarter wasn’t quite as bad as previously thought.

The market may also tighten a bit more than expected because of the declines in supply. OPEC+ stepped up compliance last month with the production cut agreement, achieving a 108 percent compliance rate. That contributed to a 2.4-mb/d global supply reduction in June compared to a month earlier, pushing global oil production down to 86.9 mb/d, a nine-year low. The market is thought to be in a supply deficit, albeit with a massive inventory overhang.

Tightening demand and falling supply help explain the rally in oil prices from negative territory in April to a more solid trading range around $40 per barrel by late June and into the middle of July.

For now, the fundamentals still point in this tightening direction. The IEA warned that U.S. supply could bottom out and resume growth, which would prevent prices from rising too much. But a record low rig count and steep decline rates from shale wells may yet translate into a further drop in output later this year. If shale rebounds, that could cap the rally, but if shale disappoints, that points to tightening.

A more immediate threat to $40 oil is the return of some 2 mb/d of OPEC+ production cuts beginning as soon as August. Libya may also return some oil to the market after lifting force majeure on its oil exports. The one-month extension expires and the cartel has hinted that it would ease cuts next month, although nothing is for certain, and the group could still decide to extend again.

In fact, despite the obvious desire from some producers to lift production again, the very downside risks that the IEA is warning about may cause the OPEC+ coalition to think twice. “For the time being…OPEC’s strategy for controlling the market appears to be working,” Commerzbank wrote in a note. “An official letter has been received from Angola in which it commits to complying with the agreed production quotas and to implementing an additional cut to compensate for the recent overproduction.”
With all producers stepping up compliance and stability returning to the market, OPEC+ would risk undoing those gains by loosening the cuts. More will be revealed in the coming days and weeks.

Commerzbank cautioned about downside risks, but struck a bullish note, arguing that “the oil market is likely to tighten in the second half of the year thanks to the massive production restrictions and further recovering demand.”

Ultimately, however, so much is unknown because of pandemic. Gasoline demand continues to edge up in the U.S., although it remains below pre-pandemic levels for this time of year. “The resurgence of the virus could trigger a more intensive use of cars to avoid public transportation and more home deliveries to avoid crowded shops. This would be supportive for fuel demand,” the IEA said. “On the other hand, the resurgence could simply reduce mobility. The impact of the recent tightening is just starting to appear in mobility data for some countries, while mobility indices elsewhere show a gradual return to pre-Covid-19 levels.”

It’s a mixed bag, but the IEA warned that the coronavirus could spoil the rally. “While the oil market has undoubtedly made progress since ‘Black April’, the large, and in some countries, accelerating number of Covid-19 cases is a disturbing reminder that the pandemic is not under control and the risk to our market outlook is almost certainly to the downside,” the agency said.

By Nick Cunningham of Oilprice.com

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