Oil Market Update: January 2021

Oil demand weakness present in December has carried into the first quarter, with a new variant of the virus prompting strict lockdowns in several countries. Product demand growth has slowed in Europe and the US, but m ost worrying for the oil market, China is experiencing its worst outbreak since the first wave, with tens of millions living under newly imposed lockdown restrictions. We subsequently expect some softness in oil pricing in the coming months, which is more likely to be expressed in physical differentials and timespreads rather than futures, given the supportive macro environment and growing positive narratives regarding commodities more generally. However, $50/bbl Brent is seen as a solid floor, given 1) Saudi Arabia’s signalled willingness to backstop short-term demand loss with unilateral cuts and 2) market reluctance to short crude whilst consensus expectations still see widespread re-opening (and an associated oil consumption pulse) in 2H-21. That said, we expect upside to remain capped through 2021. The oil market is left with significant buffers as a result of the pandemic, notably excessive OPEC+ spare capacity and liquids inventories far above the five-year average. Our forward balances suggest normalising these buffers will take until the end of this year, with prices remaining capped by the need to maintain a large delta between supply and demand to force inventory draws and rebalancing . We therefore see oil markets trapped in a sort of holding period through much of this year. Turning to 2022, with largely normalised buffers, the cap on upside pricing pressure on the oil markets will be lifted . With a positive outlook on consumption in 2022 and a weak conventional oil supply project pipeline, the market will be reliant on short-cycle tight oil supply to balance. W hilst US short cycle production is expected to eventually respond to higher prices, shareholder demands for value over volume and lower reinvestment rates will result in this response mechanism being blunted. With market price signals expected to incentivise fresh non-OPEC supply by the fourth quarter of 2021, there is a very real risk th at producers are unable to ramp up a significant volume. The market is therefore likely to shift from demand anxiety to supply anxiety regarding 2022 balances at some point in the second half of 2021, with OPEC+ spare capacity and the reactivity of short-cycle supply to higher prices in sharp focus. Prices may need to eventually reach levels that allow US tight oil operators to grow volumes and return money to shareholders, which implies at least $70/bbl WTI in an upside case. We see Brent averaging $54.5/bbl in 2021, and $61.8/bbl in 2022 in our basecase, with WTI at $51.5/bbl and $59.8/bbl respectively.