Oil prices swept up in the risk-on rally

LONDON (ICIS)–Investors have regained faith in riskier asset classes, pushing their money into commodities and stocks – liquidating positions in perceived safe havens.

The MSCI All-Country Global Equity Index (an index of small-to large-cap stocks from 23 developed and 24 emerging markets) is just 12% off pre-coronavirus levels, having collapsed by almost 35% in March.

Global oil markets are also basking in the glow of improved demand sentiment, with Brent up by 75% since April. However, with global daily new coronavirus cases hitting a record 135,000 on 30 May, is this meteoric rise stoked by sound fundamentals, or are investors getting ahead of themselves?

PHYSICAL MARKET
After a torrid April, the crude oil price recovery appears well under way. The supply cuts spearheaded by OPEC have improved fundamentals in the physical market. The discount of the Dated BFOE physical benchmark to ICE Brent futures has declined from almost $10.00/bbl in April, to below $2.00/bbl.

The recovery of the Dated BFOE has largely come in May, buoyed by the over 10m bbl/day of withheld supply.

The front-month Dubai swaps inter-month spread has also reverted to backwardation after a steep period of oversupply-driven contango.

These early signs of rebalance in the physical market should underpin futures prices. However, the supply cut agreement will see the current curtailment gradually taper off from July. OPEC and its allies will be meeting in early-June to discuss the next steps, with an extension to the pact in the balance.

The official OPEC statement said that for the subsequent period of six months, from 1 July 2020 to 31 December 2020, the total adjustment agreed will be 7.7m bbl/day and will be followed by a 5.8m bbl/day cut for 16 months, from 1 January 2021 to 30 April 2022.

OPEC kingpin Saudi Arabia and key ally Russia will have to put ideological differences aside as the market could see the easing of curbs in July as premature, skewing prices to the downside.

US PRODUCERS
The market’s initial reaction to the cut was underwhelming as participants dug down into the headline figures and found certain caveats. One of these was the role of the US in the curbs, relying on voluntary market-led production declines.

However, commercially owned US shale drillers were burnt by the low oil prices, slashing capital expenditure and shutting wells. One of the key characteristics of shale oil extraction is the need to constantly drill costly new wells to replace stagnating older ones. The sudden market collapse has already reduced US output by 1.5m bbl/day, almost as much as Saudi Arabia and Russia. The US rig count has crashed by over 65% since March.

These shut ins should be easy to recover from, with a sustained period of oil prices nearer $40.00/bbl allowing some shale producers to reopen the taps.

This latent downside potential could undermine oil prices on their road to recovery, weighing on prices when shale production becomes viable.

In the longer-term, the vast reduction in capital could be a symptom of the coronavirus that shale drillers will have to contend with for years to come.

US-CHINA FLARE UP
Optimism about the relaxation of lockdown measures has allowed equity market investors to look past the smouldering tensions between the US and China. The flare up comes after China proposed a new national security law for the region of Hong Kong. The new legislation would allow a Chinese law with criminal penalties to be intertwined with Hong Kong’s legal system. In response the US is understood to be mulling penalties against Chinese businesses.

The US is also looking to sanction Chinese officials on alleged human rights grounds.

The news has taken the wind out of the risk-on stock market rally, but it appears the upwards momentum would require further escalation to fade altogether.

Focus article by Richard Price

Front page image source: Shutterstock