Nitesh Shah (WisdomTree) | With close to half the population of China facing various forms of lock-down due to the coronavirus and many other parts of the world becoming affected (notably, Korea and Italy, where cases are growing at a rate that has taken many by surprise), the market is understandably scared that demand for crude oil will fall hard this year. Brent oil prices have fallen from a peak of US$68/barrel in the first week of January to US$56/barrel currently (24/02/2020).
Getting clear data on how much demand has already declined is difficult as data is already clouded by the lunar New Year (seasonally adjusting this data is fraught with difficulty). But we know that a sharp decline in flights, road journeys and factory activity (which can all be anecdotally monitored using satellites and thermal imagery) are likely to dent the demand for fuel. In the 3rd February release of the Caixin China Manufacturing Purchasing Managers’ Index (PMI) press release, there wasn’t even a mention of the word ‘virus’. The PMI level was above the 50 demarcations between expansion and contraction. We expect the March 3rd release for February to be very different. We would be surprised if manufacturing is able to expand in current circumstances.
OPEC stands ready to act
The Organization of Petroleum Exporting Countries and its allies (OPEC+), which collectively controls around 60% of global oil production recognises the issue. The Joint Technical Committee has already recommended to the group to cut 600k barrels of oil per day. That’s on top of the 2.1 million barrel cut (relative to October 2018) that is already in place. OPEC policy ministers are due to meet on 5th March and the larger group on 6th March. We expect them to not only endorse this recommendation, but cut deeper. In part, that is because more data on the grim situation now will be available than when the technical committee met a few weeks ago. Saudi Arabia has historically taken on voluntary cuts that go beyond what they formally sign up to do. In the last policy meeting – the first for the new Saudi Energy Minister, Prince Abdulaziz bin Salman – Saudi Arabia announced the value of the intended voluntary cuts. As long as other countries sign up to cut a little, Saudi Arabia stands ready to cut enough to balance markets.
Brent futures curve only just in backwardation
We believe that the backwardation in the Brent oil futures curve is generated by the fact that OPEC is ready to intervene. However, at the time of writing, that backwardation is close to evaporating. If OPEC cuts deeper than 600k barrels per day, we believe that stronger backwardation can be restored. Rolls yields can be an important component of returns for investors. For example, we estimate that out of the +34% return on the Bloomberg Brent Commodity Subindex (total return series), +8% came from roll yield (WisdomTree calculation from 31/12/2018 to 31/12/2019).