What the 30% oil rally in one month means?

A 33% rally in crude prices in one month does not happen without reason. What has driven this rally?

November 27, 2020 8:12 IST | India Infoline News Service
In the euphoria over the Nifty and Sensex touching new highs, most people have not noticed an interesting rally in oil. Brent crude has rallied from $36/bbl to $48.6/bbl a rally of more than 30% in less than a month.

Brent Crude Movement over last 1 year
Chart Source: Oilprice.com

If you look at the price range of Brent Crude over the last one year, it is a massive range and hints at the kind of volatility that oil saw in the last one year. From a peak of $71.5 in late Dec-19, crude fell vertically to $15.8/bbl in Apr-20. The WTI Crude even slipped into negative zone on storage concerns. This oil crash was largely driven by the large scale pandemic shutdown constricting demand. As long oil traders rushed to cover their positions, it only added to the turmoil.

The bounce from the lows was not surprising as oil gained 100% in less than 2 months. It was a mix of short covering as well as a mean reversion. However, there appears to be a larger story in the oil price rally in November 2020. A 33% rally in crude prices in one month does not happen without reason. What has driven this rally?

Is demand driving the rally in crude prices?

To an extent that is true. It has been reported that Chinese and Indian refiners have issued a slew of tenders seeking crude oil for loading in January. That clearly points to a revival in demand from two of the largest oil consumers in Asia. To support the commodity prices, the Dollar Spot Index (DXY) has also been weak, boosting the appeal of dollar-denominated commodities.

Oil trades are also stacking up oil in expectations that as factories start chugging once again at full capacity, the demand for crude from refineries could get back to pre-COVID levels. Remember, China is likely to be the only large economy in the world to show positive growth in 2020 and it is also the largest consumer of crude oil in the world.

COVID vaccine has been a morale booster

The world never believed it was so close to having a COVID vaccine. For the first time, the three foremost vaccine candidates comprising AstraZeneca-Oxford, Pfizer-BionTech and Moderna have all reported vaccine effectiveness of above 94%. It gives these companies the confidence to accept bookings and also approach the regulator for next level approval.

The vaccine is important to oil prices because it shows that finally the medium-term lag risks of the COVID pandemic may be off the table. That would mean demand finally getting back to normal levels and actually exceeding supply for some time. We shall look at this point in detail later.

Get ready for demand exceeding crude supply
Chart Source: International Energy Agency (IEA)

Oil closed at an eight-month high amid weakening dollar and optimism surrounding a surprise decline in US crude supplies. The US crude stockpiles fell 754,000 barrels last week and that is indicative that the demand could now exceed supply in a more meaningful way.

The above chart by the IEA depicts two important trends. After several quarters of supply exceeding demand and stockpiles building up, the trend is likely to change from the Dec-20 quarter. IEA expects to see five consecutive quarters of demand for crude exceeding supply and oil stock piles falling. That is likely to keep oil prices buoyant and this shift is what the rally in oil is actually hinting at.

What does this oil price rally mean for India?

For the Indian markets, at least 15-20% of the Nifty market cap benefits from improved oil price realizations. A pick up in oil prices is also indicative of a pick-up in the level of economic activity and is, perhaps, the first indication that the economy is recovering. If you add up the forward and backward linkages, the actual impact of higher oil prices could be much bigger. For example, 75% of all capital expenditure in the next 10 years in India is expected to happen in the oil and gas segment.

But there is also a downside risk to it. Historically, we have seen that when oil crosses $60/bbl, it creates a problem at 3 levels for India. Firstly, higher oil prices means the trade deficit worsens and this gets more pronounced as India relies on crude imports for ~85% of its daily oil needs. Secondly, crude above $60/bbl means OMCs have to pass on the higher costs to consumers and that can be inflationary. Lastly, it limits the ability of the government to depend on petrol and diesel as a provider of additional revenues in challenging times.

If one were to look at the Brent Futures even till the end of 2021, the estimated price has hardly crossed $50/bbl. That is positive because it hints at an economic recovery without negatively impacting government finances or inflation.

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