Coronavirus Will Crush Oil Prices
Oil is being devalued. Prices have fallen 20% since early January on lower demand expectations because of Coronavirus. For those who think that devaluation or the effects of the virus will soon be memories, think again.
The severity of the market’s view is shown most clearly in Brent 12-month futures spreads. The collapse of spreads in January and February is more drastic than previous price collapses in 2014 and 2018 (Figure 1). In 2020, spreads fell from $7.94 to zero in 34 days for a decline rate of $0.23 per day. That rate is 1.5 times greater than it was in 2014 and 1.8 times greater than in 2018.
The term structure for the February 7 Brent forward curve is approaching structural contango (Figure 2). Forward curves have been in backwardation since early February 2019 but moved into contango last week. As recently as January 31, Brent was in steep prompt-month backwardation ($1.54) and in backwardation through May, 2022. The February 7 curve was in 5-month contango.
The WTI forward curve presents an even more pessimistic view. WTI is in contango through October 2020 (Figure 3). 12-month spreads have fallen $6.34 (-113%) since January 6,
Brent devaluation may be occurring (Figure 4). Last Friday’s closing price of $54.47 was $5.24 less than one standard deviation below the 2019-2020 mean price. It was $9.47 less than the mean price of $63.94.
Same Trailer, Different Park
Supply deficits and expensive oil for most of the first decade and-a-half of this century have given way to surpluses and lower price over the last 5 years. Oil markets have struggled to adjust to the return of the old paradigm of over-supply and price deflation since mid-2014 (Figure 5).
This is the second showing of the same movie that opened after the oil shocks of 1979 to 1985. Higher prices provided incentive for producers to find new supply in places like the North Sea, Siberia and Mexico. The resulting supply surplus that followed caused low oil prices for the next 20 years.
As new fields depleted, higher prices again provided incentive to develop new supply, this time in the unconventional tight oil and oil sand plays of North America. Surpluses led to price deflation in 2014, just as they had 30 years earlier. Same trailer, different park.
Markets are people and so they are slow to accept change. After the highest oil prices in history from 2006-2014, many assumed that this was the norm and that lower prices were a temporary adjustment. That did not happen but by May of 2018, supply deficits finally returned (Figure 6). At the same time, the United States announced it would withdraw from the Iran nuclear pact and put oil-export sanctions on Iran.
Prices rose to the highest levels since 2014 and some analysts predicted $90 oil prices by the end of 2018. When the U.S. granted export waivers in October, prices collapsed. Since then, three successive price rallies have failed to approach October levels. That is because these rallies have been chiefly driven by geopolitical factors that were not supported by supply-demand fundamentals.
The most recent rally required three concurrent geopolitical events—a new OPEC+ production cut, a U.S.-China trade deal and the assassination of Iranian General Soleimani. Still, WTI did not reach $62.
Coronavirus Will Crush Oil Prices
In December, I predicted that higher prices would not last and in fact, the rally failed in the first week of 2020. Then, news of the Coronavirus in China began to dominate market sentiment. The result has been a 20% decline in oil prices. So far, broader markets seem largely unaffected. I do not take comfort in that because oil is commonly a bellwether. Energy is the economy.
Predictions and opinions about Coronavirus are largely useless because the reality is that no one knows enough to make predictions yet. Comparison to the SARS epidemic in 2003 is interesting but only marginally relevant. SARS was also a coronavirus but it was transmitted by person-to-person contact. The latest version is airborne and that changes everything.
SARS occurred when China was a $2 trillion economy. Now it is a $14 trillion economy. Chinese oil consumption is 7 times what it was in 2003. Global supply chains are much more complex and integrated today and China is central to all of them.
Oil prices rise and fall on daily news that is either more or less hopeful about containment and death rates. It is not contained and death rates are a total guess at the moment.
Markets seem to be assuming that Coronavirus is an Asian phenomenon. It is not and will unavoidably become a global problem. Markets will respond quite differently once this is understood. A major sell-off in broader markets seems almost certain.
Chinese efforts at containment are unparalleled and unimaginable in less autocratic countries. So far, it is unclear that containment progress has been made. Some argue that healthcare infrastructure is better in North America and Europe than it is in China. That may be but whatever facilities exist will likely be overwhelmed in short order.
I want to be optimistic but frankly cannot believe most of the information that passes government censorship. If a cure is found today, the effect of the disease on global markets will be severe. Since that is not the case, I have a hard time imagining an outcome that will not crush oil prices.
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