Crude oil prices tumble on demand concerns

Oil watchers are terming the Chinese oil demand shock as a black swan event.

February 28, 2020 2:09 IST | India Infoline News Service
A little over 3 months back, when the Iran-US conflict was reaching a crescendo, the Brent Crude prices had inched closer to $70/bbl. That almost looks like a distant memory with Brent Crude now getting perilously close to $50/bbl. Effectively, oil has lost nearly 30% from its peak in the last quarter as you can see in the chart below.
Chart source: Bloomberg
The shaded portion shows the sharp fall in oil prices in the last 3-4 months. Of course, the Coronavirus syndrome came only in the last one month, although the impact on oil demand has been larger than expected. The point is that the oil has been facing insufficiency of demand growth for some time now. Even as the trade war between the US and China showed signs of abating, the virus pandemic was the big hit to demand. China remains the largest importer of oil and the second largest consumer accounting for 13% of world demand. But, before we get into the Chinese pandemic, let us look at the larger issue of oil demand and how it has grown at an awfully slow level over the last decade and half.

Problem of weak oil demand

Even though the actual slowdown in demand is a more recent phenomenon, the chart will depict that demand has been growing at an extremely slow rate for close to a decade and half. This is more because the structural demand had peaked and additional demand for oil was more incremental in nature. That is evident if you look at the global oil demand chart.
Data Source: Statista
The flat slope of the trend line is indicative of the fact that CAGR in oil demand between 2006 and 2020 was less than 1.25%. That kind of weak demand growth makes the price of oil extremely vulnerable to both supply and demand shocks. For example, in 2014, it was the US shale supply shock that took oil price down from $110/bbl to $60/bbl. Later in early 2016 as the US hiked Fed rates for the first time, it was the expected demand shock that pulled crude to $30/bbl. The latest fall in early 2020 has been led by a sudden fall in demand from China as scores of factories shut down and fuel demand has fallen. This weak demand growth is making oil extremely vulnerable to sudden shocks. In this case, the latest shock has come from the Chinese Coronavirus.

Chinese Coronavirus and why it matters to oil

As we write, the China Coronavirus death toll is closer to 3,000 and close to 1 lakh persons across the world are afflicted by the disease. To that extent it is truly a global pandemic. China is not only the second largest consumer of crude oil but also the largest importer and hence it remains the largest swing consumer to determine oil prices. China consumers 14 million bpd of crude and that is more than the combined consumption of France, Germany, Italy, Spain, UK, Japan and Korea. The rapid spread of the virus across China has led to a 20% fall in oil demand (equivalent to 3 million barrels per day); something huge for a swing consumer. This is largely attributable to the lockdowns and the halt in economic activity across large swathes of China. In addition, many airlines have shut flights to China and most large companies avoid travel and confine themselves to video conferencing.
Oil watchers are terming the Chinese oil demand shock as a black swan event. In terms of the quantum of the shock, experts believe that this is equivalent to the shock caused by the temporary recession in 2008-09 post the crash of Lehman Brothers. In terms of suddenness, the impact is almost equal to the immediate aftermath of 9/11 in the year 2001. Whether this China syndrome will force OPEC to cut the production remains to be seen. But we will deal with that in the next point.

Why an OPEC supply cut is unlikely to be effective

Even as the OPEC and Russia meet up in Vienna, there are two questions; will OPEC venture for a supply cut and will Russia support OPEC in this move. In a sense, OPEC is unlikely to venture into supply cuts unless there is unequivocal support from Russia. The share of OPEC in global oil production has fallen from 60% in the late 1990s to just about 35%. Among the 10 largest oil producing countries, only 5 are OPEC nations. Russia may be wary of participating in the supply cuts as in the last few years; the biggest beneficiary of such supply cuts has been the United States. They have managed to sell more oil with each bounce in oil prices. OPEC may be wary of undertaking supply cuts without Russia because it is hard to cut supplies and hold prices when there is demand slowdown. OPEC may only end up diluting its position and its clout among the existing members.
In a nutshell, weak oil prices may be here to stay. The Chinese virus may have just exacerbated the fall. The only hope for oil is a major monetary stimulus by China and a V-shaped recovery in oil demand. That does look tough at this point of time!

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