TD Economics: Oil prices crash on expectations of simultaneous demand and supply shocks

By Omar Abdelrahman
Economist

Oil prices continued their freefall over the weekend as Saudi Arabia signalled impending production increases and slashed the prices offered by its state producer on Saturday. The Brent and WTI (West Texas Intermediate Crude Oil) price benchmarks fell more than 20% to US$36 and US$33, respectively. Both benchmarks are now trading at their lowest levels since 2016, when prices were still reeling from the 2014 supply-driven oil shock.

This slump follows a near-10% decline in prices on Friday, when OPEC's 178th Meeting of the Conference and the 8th OPEC (The Organization of the Petroleum Exporting Countries) and non-OPEC Ministerial Meeting concluded with disagreement on a proposed 1.5 million barrels per day cut.

The proposed cut was recommended by an OPEC committee in response to the COVID-19 outbreak, with 1 million barrels per day (bpd) of the cut allocated to OPEC and 0.5 million allocated to Russia and other non-OPEC countries. If agreed upon, these cuts would have resulted in a cumulative 3.6 million bpd being off the market (an existing 2.1 million bpd of cuts were already in place) and would have likely instituted a price floor. Russia had been reluctant to curtail production further following the December meeting, and wanted to take a wait-and-see approach on how demand evolves in response to COVID-19. At the same time, Saudi Arabia had been signaling its unwillingness to shoulder a further production cut on its own.

This breakdown in OPEC+ talks also implies an end to the existing 2.1 million barrels per day curtailment in place since December of last year, which were set to expire at the end of this month. These cuts were agreed upon prior to the COVID-19 outbreak, with the intention of offsetting anticipated surges in in Non-OPEC supplies (U.S. shale, Brazil, Norway) in 2020.

There are no indications yet by OPEC producers on the magnitude of production increases to be expected. Saudi Arabia's latest production estimates stand at around 9.7 million bpd (as per latest data in Bloomberg). Its capacity, at around 12 million bpd, can be quickly brought online, implying upwards of 2 million barrels per day of potential additional supply.

Key Implications

The response in oil markets to the combination of demand and supply shocks has been to send benchmark prices more than 45% below their January highs. On the demand front, the COVID-19 outbreak has been impacting expectations for the year and is already driving demand destruction as quarantine efforts reduce demand for jet fuel and gasoline. Indeed, the International Energy Agency today published revised estimates in its March report, suggesting a 90k bpd drop in demand for the year. If realized, this would be the first drop in demand since the financial crisis. The possibility of a pandemic could bring down demand down even further.

On the supply front, markets were already facing sizeable new supply additions this year from Brazil, Norway, and the United States. The latest breakdown in talks implies a potential addition of up to 2.1 million barrels per day to an already-oversupplied market.

In terms of implications on our WTI price forecast, we anticipate prices to remain pressured into the second quarter as OPEC's production increases materialize and supply-demand imbalances worsen. An expected inventory build-up will delay a sizeable recovery in prices even as demand starts to pick up in the third quarter. We expect WTI prices to trend up to the US$40-45 mark by year-end.

The breakdown of talks between OPEC+ countries also implies higher volatility in the near term. In the past three years, previous OPEC+ agreements had kept prices relatively stable in the US$50-60 range.

Of course, our outlook is rapidly evolving as new information on the COVID-19 spread comes to light. Several risks to the outlook include:

  • OPEC+ producers could go back to the negotiating table and agree on a production cut if prices remain low for long.
  • High cost producers may voluntarily shut-in production temporarily. On that note, U.S. shale, the biggest wildcard, may also slow down. There is significant uncertainty with the respect to the degree by which U.S. shale production will slow in response to tanking prices. While rigs drilling is expected to slow, many producers are likely hedged for a sizeable portion of 2020 production. Additionally, there is a stock of drilled but uncompleted wells (DUCs) that may be brought online if prices tick up above the US$50 range.
  • Demand may take longer to pick up if the COVID-19 outbreak escalates into a pandemic, delaying the recovery in demand and prices.

For Canada, the net impacts are negative given Canada's position as a net oil exporter. We are in the process of reviewing our real GDP forecasts for the year as a whole, and are penciling in an expected terms of trade and income shock. Provincially, Alberta, Saskatchewan, and Newfoundland and Labrador's real GDP forecasts will likely be downgraded significantly for the year. Additionally, some of the aforementioned provinces may need to fill a sizeable gap in their commodity-sensitive budgets given the marked slump in oil prices.

Omar Abdelrahman

Economist

TD Bank Group