Thursday, April 23, 2020

Has Brent bottomed out amid the supply and demand crisis?

  • Oil
  • Brent


Analysts’ Pick: Has Brent bottomed out amid the supply and demand crisis?

  • Shrinking storage spaces for oil is likely to drive costs higher, possibly reducing arbitrage interests in the short-term
  • Demand will likely continue to weigh on oil prices especially an immediate recovery is unlikely as lockdowns will only be eased incrementally
  • High inflows into oil-tracking ETFs may start to weigh on demand as a result of the recent drop of WTI’s May contract into negative prices

Oil futures made history earlier this week, with the WTI May contract pushing well below zero into negative territory to close at -US$37.63 per barrel on Monday. Multiple oil-tracking ETFs were also liquidated as a result.

WTI crashed into the negative zone on Monday as traders rushed to offload the expiring contract


The historic negative oil prices suggest a couple of issues surrounding crude oil prices. First, the oversupply issue in which the world is running out of storage space for crude oil, as a result of a increased production earlier in the year from the breakdown of OPEC+ which saw Saudi Arabia and Russia hiking output to compete for more market share. The negative oil future contracts highlighted the market’s sentiment that it would be cheaper to pay the counterparty to buy the contract instead of actually allowing the contract to be settled, and pay for storage of the physical delivery of oil. Secondly, it also highlights the current levels of speculation in oil markets.

Brent crude oil futures flipping into a super contango from six-months ago


On the speculation end, both Asia and the US saw an influx capital flow into ETFs tracking oil. The 13 crude-related ETFs in Asia saw a record US$803mn inflow of funds during the week of April 3rd, likely as retail investors saw the historically low oil prices as a buying opportunity. But Monday's negative WTI crude oil futures contract highlighted the underlying issues with this. US WTI contracts require purchase on expiry, i.e. the purchase of the physical barrels of oil on the specified date of the contract. As the May contract approached its expiry on Tuesday, most oil-tracking ETFs would have needed to shift to the June contract. This was likely one of the causes of the large swing in prices for the WTI crude oil futures contract for May, resulting in a drop past zero. In addition, the United States Oil Fund (USO) exhausted its total number of shares available for issue, forcing it to apply for with regulators to issue more on April 20th. Thus, the fund can't purchase more future contracts until approval. As a result, ETFs have tweaked their mandate to hold longer-dated future contracts. The USO changed its composition to hold 40% of the current active June contract, more for the July contract and 5% in the August contract. But it still holds a considerable portion of the total June contracts. This means that there may also be more volatility for oil when the WTI June contract expires as well while USO’s shortage of shares might weigh on demand for oil futures in the short-term, before attaining approval to issue more shares.


In the US, the Energy Information Administration (EIA) reported that the US' storage capacity is now 60% full on a whole. This figure has risen since the start of the year as a result of China's lockdown in its Wuhan province (one of the manufacturing hubs in China) which weighed on demand for energy. The effects were further amplified after OPEC+ talks broke down in resulting in Saudi Arabia and Russia increasing their production capacity since March. The global lockdown also dampened oil's outlook, with demand for jet fuel dented travel routes were reduced amid the Covid-19 pandemic. Gasoline prices has also nosedived, thanks to the imposed lockdowns. Cushing, Oklahoma, the largest oil-storage tank farm in the world which takes up 13% of the US' entire storage capacity, is now 76% full, after its inventory increased 4.8 million barrels during the week ended April 17th.

Cushing’s crude oil inventory surged over the past four weeks, and is approaching its limit


In other parts of the world, storage space for oil are also building up at a rapid rate. According to Vorexa, the Asian region now accounts for roughly 45% of total global floating storage. This signals that onshore refinery and storage facilities may be reaching capacity limits. Vorexa's report also noted that the estimated cost for Very-Large Crude Carriers (VLCCs) is US$80,000/day for six months, which translates to approximately US$7.60 per barrel of crude (VLCCs have a storage capacity ranging from 1.9mn to 2.2mn barrels) which is lower than the current six-month Brent contango of US$10.90 per barrel. This implies that oil traders are still expecting prices to recover in the next six month and are taking advantage of the current implicit arbitraging via physical delivery of oil. This should hold steady, in the middle-term, but may fall short in the near future as oil tankers fill up at an exponential rate as a result of oversupply and dented demand, putting upward pressure on storage costs as well. This could dampen oil prices in the short-term further if storage prices continue to rise as opportunity for arbitrage falls.

Storage costs is currently still lower than the six-month contango of Brent crude oil futures


In demand, our outlook remains mostly in line with previous reports. Oil consumption should remain low, as evident from depleting storage spaces in the short-term. As countries start to ease lockdowns, demand should pick up, but a proper recovery is likely to only be seen in the second half of 2020 or later since we expect lockdowns to only be eased incrementally. Hence, Brent and WTI are likely to remain low and in a super contango in the short-term. But the sell-off should ease a little as the production limit by OPEC+ kicks in from May 1st onwards, although the tangible effects on oil prices will likely only be felt later. As a result, we expect Brent to be tilted to the downside in the short-term, possibly falling back towards 18.00’s level before experiencing a small rebound to 25.15's level in the short-to-medium-term.

Technical Analysis:         


Oil bears are in possession of Brent at the moment as both supply and demand woes will likely plague oil prices in the short-term. High levels of speculation have also weighed on the index, causing a sharp drop on Monday as its US counterpart (WTI) went beyond zero into negative prices. RSI suggests that Brent is not oversold yet, and with fundamentals tilted to the downside, there may be more room for the benchmark to drop. But the downside should be limited, and we expect another push from bears to try to break the resistance of 19.89. Oil prices is likely to also stay low in the short-term especially after the large swing in prices cemented that the initial rebound could not last. We may not have seen the bottom however, as the OPEC+’s production limits only kick in within a week, and a 9.7mn barrel cut may not be enough to immediately save oil prices. Hence, as a result we expect Brent to be able to break the 19.89 support level and trend towards 18.00, although the downside from there onwards is much less pronounced.

Support: 19.89 / 18.00 / 16.00

Resistance: 25.15 / 28.47 / 35.52

Brent Chart (H4)