Commodity Supply Balance: How Production Cuts have Caused Bullish Sentiment on Commodity Markets

Abstract:

The dual black swan events of the COVID-19 pandemic and oil price war have created a unique analytical opportunity within petroleum products. As oil prices crashed, natural gas prices have largely remained unchanged due to the markets in which the commodities are used. Transportation which is the main use of oil has almost entirely stopped, whereas electricity generation and heating, the destination for most natural gases has remained similar to pre-2020 levels. Such modifications to consumption caused markets to go haywire and commodity prices to crash. With crude production cuts now occurring at a faster pace than anticipated and states lifting restrictions, supply and demand dynamics for liquids compared to natural gas has changed since April. As the United States begins returning to normal, an update to these commodity market assumptions is in order.


Introduction

At the end of April, the RP News Team reported on “Natural Gas Rebound Poised for Recovery Before Crude Oil: Why the Market has Priced Electricity and Liquid Fuel Demand into Commodity Prices.” In the past six weeks the world has gone through the gauntlet, and there are important updates that have occurred relating to the article. The April report notes the dual black swan events of the COVID-19 pandemic and oil price war created a unique analytical opportunity within petroleum products. The strip price for natural gas was showing larger percentage increases than crude or NGLs because the market had priced in the assumption that electricity demand would not fall as quickly as the oversupply of natural gas. While refined fuel consumption like jet fuel and gasoline fell to multi-year lows due to stay at home orders in Q1 and Q2 2020, electricity generation and heating from natural gas was not expected to fall as much over the same period. With crude production cuts now occurring at a faster pace than anticipated and states lifting restrictions, supply and demand dynamics for liquids compared to natural gas has changed since April. As the United States begins returning to normal, an update to these commodity market assumptions is in order.

The original assumption recognized the oversupply of natural gas was expected to correct faster than crude oil because a majority of crude oil is utilized in transportation (hit hardest by the pandemic) while a majority of natural gas consumption is used in power and heat generation (only slightly affected). As a result, the futures strip price for natural gas was showing larger percentage increases over time than crude or NGLs because the market was pricing in the assumption the oversupply of natural gas would fall faster than electricity demand. Factors for these assertions include the sources allocated to electricity generation, changes in electricity usage and demand due to COVID-19, anticipated oversupply for refined crude products, and anticipated production decline for hydrocarbons due to current market forces. The market recognizes the demand declines experienced in the natural gas sector have, and will continue to, dwarf in comparison to the destruction of the crude oil and associated liquids markets. With decreased travel continuing to buoy gasoline, ethanol, and jet fuel supplies, crude demand was predicted to be unable to correct its oversupply as quickly as natural gas. 

Recent Major Commodity Moves

Since April there have been some significant developments in the oil and natural gas markets. The first and most important being MAJOR global production cuts that have helped bring oil supply and demand back towards equilibrium at a rapid rate. While many argued a 12 MMBPD cut in May and 14 MMBPD cut in June would not be enough, prices have stabilized and inventories have begun to draw down in May (Table 1), indicating actions taken were just the right amount at a much needed time. Analysts at IHS Markit have speculated that global production cuts will be based on several factors simultaneously including “technical, logistical, regulatory, contractual, and financial conditions” [14]. Forces relating from civil unrest and additional COVID lockdowns may cause more shut-ins outside of the agreed upon cuts. This could potentially result in global supply cuts for Q2 2020 ranging from 14 to 17 MMBPD year-over year [15]. Such dramatic cuts also brought plenty of associated gas offline. Although domestic gas production has not fallen significantly since the prior posting, demand has certainly dropped.  While crude oil inventories had been building for months, the U.S. saw storage drawdowns during the weeks of May 8th and 15th. All of these drawdowns were eliminated the week of May 22nd with a 7.9 million barrel build, bringing storage inventories to a new high as seen in Figure 1. Although the situation is still tense, the crude commodity market seems to be correcting itself quicker than previously expected (Tables 2 and 3). 

Figure 1: Domestic Crude Oil Inventories [1] 
Figure 2: Domestic Natural Gas Inventories [2]

Similar to crude inventories, natural gas storage has been building during the pandemic but has not deviated from the 5-year range. Figure 2 shows there are historically drawdown and buildup seasons. Even though the build in 2020 started earlier than normal due to the coronavirus pandemic, inventories are still well within the 5-year highs and are only slightly above the 5-year average. As of May 22nd, the U.S. Energy Information Administration reported that domestic storage of natural gas rose by 109 BCF for the week and total stocks now stand at 2.612 TCF[2]. This is up from 1.834 TCF a year ago and 423 BCF above the five-year average [2]. Luckily, storage trends due to the pandemic have only shifted by a few weeks and are not rising at a faster rate than average. Additionally, natural gas prices are trading sharply higher on expectations of lower production and increased demand as the economy starts opening up. As the summer cooling season approaches, lower gas production is likely the primary driver of this rally. 

New Market Assumptions from June Data

At the end of April, crude oil commodity futures prices were expected to recover 38% by February 2021. This was a result of disastrously low oil prices and a storage problem that seemed unsolvable due to decimated demand and soaring supply. Since then, the world has come together with agreements to bring 12 MMBPD production offline in May, and has a plan in place to slowly bring supply near pre-pandemic levels in 2021 as demand returns. Such incredible actions in the past month have elevated commodity prices in the near term and likely created a smooth recovery for oil prices into the future. As a result, crude futures currently estimate a 79% recovery in prices from the same May 2020 period through February 2021, up from the 38% recovery back in April. Table 2 shows an updated percentage change for the three commodity streams between the average May future price and current February 2021 futures price. While they all still increase over time due to contango, the variance in crude prices has moved much closer to the other streams. This spells good news for the oil industry as markets predict a quicker recovery in prices as a result of the world taking action to address the global oversupply problem. While futures for natural gas are down slightly compared to April, prices are still expected to recover as a global oversupply was not as dire for gas markets. 

The new projected data shows the change in market assumptions that crude oil is expected to recover from the pandemic and stabilize far sooner than expected a month ago as a result of global production cuts. While gas prices are still expected to increase, the projected recovery has fallen slightly. Current futures for natural gas are now expected to change less than crude oil on a percentage basis into February 2021. Throughout the pandemic, the gas supply-demand imbalance did not force the same pressure on gas markets as crude, so natural gas production did not need to react as much to ensure stable commodity prices. As crude players jumped to bring production offline, gas players benefitted as associated gas production from shale wells was brought offline. Since gas demand was less affected by the pandemic, these actions will help move natural gas supply back into balance. Although prices are no longer expected to peak into the $3/MMBtu range estimated in April, the future remains bright for gas. In fact, the EIA forecasts natural gas prices will generally rise through the rest of 2020 (Table 2) as U.S. production declines and demand increases. The Henry Hub natural gas spot price is forecasted to average $2.14/MMBtu in 2020 and then increase in 2021, reaching an annual average of $2.89/MMBtu as a result of lower natural gas production compared to 2020 [3]. 

Not much has changed in the NGL markets since April except current lower commodity prices as the world utilizes less hydrocarbon gas liquids than previously expected. Regardless, the markets have faith for a stable price rebound in the NGL market soon. 

Conclusion

Despite U.S. citizens staying home and contributing to more residential electricity demand, this has not offset the decrease in other forms of electricity demand like commercial buildings, factories, and other large industrial users. As economies begin to reopen, the world will begin to usher in a new age and a new normal for energy demand. Such times will see more individuals working from home, consuming more residential electricity, and using less fuel for personal transportation. In April the industry was facing a supply-demand storage imbalance spiraling out of control, which sent WTI futures prices into the negative territory for the first time in history. As a result, the world came together and brought an unprecedented volume of crude production offline to begin correcting the imbalance. Six weeks later, data in the futures market shows confidence for a steady recovery through February 2021, a much brighter outlook than April projections. The percentage variance for all three commodity streams has moved closer from May 2020 to February 2021, showing there are not any major assumptions built into the price for only one commodity (Table 3).

Commodity prices have continued to project natural gas and NGL markets to recover, but currently at less of a rate than their transportation fuel related cousin. Due to current low commodity prices, gas production will continue to naturally drop. It will be magnified by the reduction in associated gas as oil wells are shut-in to comply with global production cuts. Pair this with gas storage expected to decline from peak winter season usage and the natural gas oversupply will continue to correct faster than the reduced electricity demand into 2021. Travel will be reduced as a result of the coronavirus and fuels generated from oil will have decreased demand, but this will be balanced by dramatic supply cuts and increased usage in freight fuels as people order more packages to their homes.  

Table 3 shows the percentage change expected for commodity futures at the end of April and again at the beginning of June. The change month over month shows how the market corrected its assumptions about crude prices as production was shut-in during the month of May. It has also taken into account lockdown orders easing which will result in more fuel usage. While there has been a drop in predicted gas and NGL recovery, crude has blazed ahead from April’s estimates. Faith is still strong in natural gas as it is the commodity that will continue to be needed for electricity and heating in residential, commercial, and industrial buildings. As a result, the market has built these assumptions into futures pricing which is now anticipating a 59% change for natural gas and a 67% change for NGL futures between May 2020 and February 2021. The current 79% change for crude oil futures, a 40% rise from April estimates, in the same period is disproportionate to the other streams. The assumptions for natural gas compared to crude commodities in the futures markets have now corrected as oil production was slashed faster than anticipated.

References

[1] https://www.eia.gov/petroleum/weekly/crude.php 

[2] https://www.fxempire.com/forecasts/article/eia-build-comes-in-as-expected-650682 

[3] https://www.eia.gov/outlooks/steo/ 

[4] https://www.cmegroup.com/trading/energy/ 

[5] https://www.investing.com/commodities/

[6] https://momr.opec.org/pdf-download/ 

[7] https://www.reuters.com/article/us-oil-opec-survey/opec-delivers-three-quarters-of-record-oil-cut-in-may-survey-idUSKBN23520D 

[8] https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCRFPUS2&f=W 

[9] https://www.richmond-news.com/business/canada-agrees-to-oil-production-cuts-1.24117137 

[10] https://www.reuters.com/article/us-opec-canada-oil/alberta-cuts-oil-output-by-1-million-barrels-per-day-minister-idUSKBN2332QJ?rpc=401& 

[11] https://www.argusmedia.com/en/news/2092548-petrobras-cuts-brazil-oil-production-by-9pc 

[12] https://petrobras.com.br/en/news/production-sales-report-released.htm 

[13] https://www.reuters.com/article/us-global-oil-norway/norway-to-reduce-oil-output-from-june-to-december-oil-ministry-idUSKBN22B37P#:~:text=%E2%80%9CWe%20will%20cut%20Norwegian%20production,Oil%20Minister%20Tina%20Bru%20said

[14] https://www.worldoil.com/news/2020/5/8/crashing-oil-demand-drives-a-17-mmbpd-global-output-cut-in-q2

[15] https://www.naturalgasintel.com/articles/121934-global-oil-supply-cuts-now-seen-reaching-17-million-bd-in-2q 

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