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Oil: Supply-Demand Dynamics As Vaccines Emerge

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Oil: Supply-Demand Dynamics As Vaccines Emerge

By Erik Norland

The oil market’s reaction to news of two potentially highly effective COVID-19 vaccines seemed peculiar. Given the pandemic’s continued, and escalating, presence in the United States and Europe, one might have expected a relatively tepid price response from short-dated futures contracts, in contrast to a robust rally from longer-dated contracts. Instead, the opposite happened. Oil futures for delivery in the next few months rallied much more than those to be delivered in one or two years (Figure 1).

Figure 1: Short-dated futures responded more positively than long-dated futures to the vaccine news

Figure 1: Short-dated futures responded more positively than long-dated futures to the vaccine news

There are expectations for the vaccines to be used in a very limited way as soon as possible, but they are not expected to be widely available for several months. Meanwhile, both the US and Europe continue to experience an increase in COVID-19 infections.  In the US and Europe, economies are still far from operating at normal levels. The UK economy was down 8% year over year at the end of Q3, and Japan, the eurozone and US were down 3-4% year on year (Figure 2). In Q4, somewhat less stringent- than- before lockdown measures were reintroduced in much of Europe and limited measures are also being implemented in certain U.S. states. This might impact their Q4 economic growth.

Figure 2: A Q3 rebound left major economies far from a fully recovery

Figure 2: A Q3 rebound left major economies far from a fully recovery

Economic growth in China has been better. GDP growth returned to 4.9% in Q3 and industrial activity has been advancing at closer to 8-9% year on year in recent months. Moreover, Q4 2020 growth appears to be quite robust thus far in the world’s second largest economy. Other emerging economies are not doing so well. Russia and India continue to suffer from the economic effects of the pandemic, and COVID-19 cases remain remarkably high across much of Latin America. The state of the global airline industry, responsible for about 10% of crude oil consumption, remains dire: for example, passenger traffic was down 63.4% in the week ending November 17 (Figure 3).

Figure 3: Air travel remains 63% lower than a year ago in the week of November 17.

Figure 3: Air travel remains 63% lower than a year ago in the week of November 17.

Inventory levels for crude oil and refined products have been coming down but, with the exception of gasoline, remain high compared to recent years (Figures 4-6). On the supply side, OPEC + Russia as well as U.S. producers have been exceptionally disciplined in calibrating their production to the level of demand. Doing so was relatively easy during the summer as the world reopened from lockdowns in the spring. Oil demand, however, has become much more variable as the Northern Hemisphere heads towards winter.

Figure 4: Crude oil inventories remain elevated

Figure 4: Crude oil inventories remain elevated

Figure 5: Ultra-Low sulphur diesel inventories are falling quickly but are still high

Figure 5: Ultra-Low sulphur diesel inventories are falling quickly but are still high

Figure 6: Only gasoline inventory levels are in the normal range

Figure 6: Only gasoline inventory levels are in the normal range

In the aftermath of the 2014-16 oil price crash, OPEC + Russia maintained production quotas for about two years before the competition for market share resumed near the end of 2018. After the crash in oil prices in the spring of this year, and given the continued uncertain state of the global economy, they can be expected to continue cooperating to keep a lid on production until well into 2021 or even after. 

Meanwhile, vaccines could release enormous pent-up demand for travel once they are widely adopted in 2021. This creates the possibility of a rapid recovery in oil demand. By mid-2021 oil inventories might have fallen further towards normal levels. Moreover, once supply is taken offline, it can take a while to get it back on. As such, one might wonder: is the preponderance of risks to oil prices this winter to the downside? And, are there substantial upside risks later in 2021 as travel potentially recovers more quickly than oil production? The answer may depend to some extent on economic stimulus. Without fiscal support from the U.S., EU and other governments, it’s not clear if pent-up consumer demand for travel and other goods and services will be enough to generate a strong economic recovery.

Bottom Line:

  • Vaccine news produced a stronger response from short-dated than long-dated oil contracts
  • Given the pandemic, are short-term risks to oil demand weighted to the downside?
  • Given potential delays in restoring production, when the pandemic ends, are risks weighted to the upside?
  • Inventory levels remain high but are coming down, and oil producers remains disciplined

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