Oil: The problem is not supply, it’s demand

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April 14, 2020 10:57am NYSE:USO

NYSE:USO | News, Ratings, and Charts

 

  • The market was hungry for a production cut
  • Russia and Saudis insist on an across the board agreement
  • The problem is not supply; it’s demand

 

Herding cats is no easy feat. Cat owners know that organizing the animals to move in the same direction is a futile exercise as they are inherently uncontrollable. Many cats tend to fight with each other and do not adapt to group behavior well. A group of cats is called a clowder.

The price of crude oil fell from $65.65 per barrel on the nearby NYMEX futures contract in early January to a low of $19.27 per barrel in late March, a decline of over 70.6% from high to low. Over the same period, the Brent benchmark dropped from $71.99 to $21.69 per barrel or just under 70%. The bear market picked up steam on the downside following the March 6 meeting of OPEC and the Russians, where the cartel decided to abandon production quotas and flood the world with the energy commodity. The move caused problems for all oil-producing nations around the globe at a time they faced a global pandemic that has destroyed demand.

With NYMEX crude oil sitting below $22 per barrel, producers were talking about production quotas to support the price of the energy commodity (which they got last weekend). Think of the oil-producing nations as a clowder that could be impossible to herd. The United States Oil Fund (USO) and the United States Brent Oil Fund (BNO) track the price action in the two benchmark crude oil futures markets.

The market was hungry for a production cut

The Saudis and Russians could not agree to a further production cut on March 6, which led to a flood on crude oil that sent the price of the energy commodity below the $20 per barrel level.

(Source: CQG)

The weekly chart highlights the move to a low of $19.27 per barrel on March 30. A combination of evaporating demand and a massive increase in supplies pushed the price of crude oil to its lowest price since 2002. While Saudi Arabia and Russia may have believed that the decline in the price would push US producers from the market, the move wound up shooting all oil-producing countries in the foot.

With crude oil flirting with the $20 per barrel level and some analysts calling for the price to fall into the single digits, the producers realized that they had no choice but to act.

Russia and Saudis insist on an across the board agreement

Last week, oil producing nations from around the world discussed the potential for a worldwide cut in output of ten million barrels per day. Russia and Saudi Arabia insisted that any reduction would need to be across the board with all nations, including the United States, participating.

Russian President Vladimir Putin said that he wanted the see the price recover to the $42 per barrel level on the Brent benchmark, which would put nearby NYMEX futures around the $40 level. However, he insisted on widespread participation. At the end of last week, OPEC plus the Russians held a video conference call and invited all other producing nations to participate in an unprecedented move. While all countries, including the United States, agreed to reduce output, Mexico turned out to be a holdout. The consensus called for a 400,000 barrel per day decline in production from the Mexicans, but they would only agree to a 100,000-barrel cut. In a press conference on Friday, April 10, US President Trump said that the US decided to make up the difference for Mexico, and the Mexicans would “pay the US back” at a later date. At the end of last week, it appeared that deal for a two-month ten-million-barrel cut was achieved, with plans to scale it back over the coming months as demand returns to the oil market.

Ironically, President Putin’s target for crude oil at the $42 level would fill the gap on the weekly chart from $36.35 to $41.05 per barrel on the nearby NYMEX futures contract. In futures markets, price action typically erases voids on charts over time.

Crude oil plunged quickly after the early March decision to flood the market. However, the price was heading lower anyway because the issue facing the international crude oil market is not from the supply side.

The problem is not supply; it’s demand

The global pandemic caused a deflationary spiral in markets across all asset classes. In crude oil, OPEC and Russia’s decision to flood the market hastened the decline, which was likely coming sooner rather than later. In the aftermath of a deal to trim global output by ten million barrels each day for the coming two months, we could see a rebound in the price of the energy commodity. We should not expect too much on the upside until demand returns. With people all over the world staying at home, nonessential businesses closed, airplanes idle, and unemployment levels rising to unprecedented levels, demand continues to be the main factor weighing on the price of crude oil. Bullish news for oil will eventually come from scientists when they come up with effective treatments and a vaccine that end the loss of life and the rising number of infections. Opening the global economy is the only thing that will get the price of crude oil higher. It’s all about demand in the crude oil market over the coming months.

The clowder of oil producers around the world displayed panic, which led to cooperation on a supply reduction last week. Herding those cats turned out to be unprecedented. It was a sign of how the global pandemic transcends borders, political ideology, and all other factors that separate people around the globe.

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The United States Oil Fund LP (USO) was trading at $4.76 per share on Tuesday morning, down $0.17 (-3.45%). Year-to-date, USO has declined -60.37%, versus a 6.18% rise in the benchmark S&P 500 index during the same period.

USO currently has an ETF Daily News SMART Grade of F (Strong Sell), and is ranked #65 of 109 ETFs in the Commodity ETFs category.


About the Author: Andrew Hecht

andrew-hechtAndrew Hecht is a sought-after commodity and futures trader, an options expert and analyst. He is a top ranked author on Seeking Alpha in various categories. Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup. Over the past decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities. Aside from contributing to a variety of sites, Andy is the Editor-in-Chief at Option Hotline.


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