FxWirePro: Demand/Supply Equation & Hedging Strategy of Brent Crude

After six consecutive weeks of stalling global mobility, we trim our 2H’20 demand assumptions by 1.5 mbd. The core demand scenario calls for a shallower recovery, rather than a renewed sharp downturn as governments, businesses and consumers adapt to live with the pandemic.

It is foreseen that the global demand rising by 4.4 mbd over 2H, mainly driven by diesel (1.6 mbd), with jet fuel/kerosene demand contributing 940 kbd and gasoline demand only growing by about 670 kbd.

Overall, we now see global demand moving from around 90 mbd in July to 94.4 mbd in December, with 4Q20 averaging at a level roughly 7.1 mbd lower yoy.

The pause in demand is taking place at a time when more supply is creeping back to the market and global refineries are showing signs of limiting throughput to work down product stocks.

Global crude oil supply is set to rise 4.3 mbd between July and December and 6.2 mbd from June lows.

Our model still assumes improvements in demand outpacing supply through the end of the year, but we now see deficits narrowing from 2.6 mbd over 4Q’20 to 1.3 mbd currently.

This means that out of the total 1.37 billion barrels of oil inventory accumulated in Jan-May, only about 300 million barrels will be drawn between June and December.

Crude inventories will likely draw 350 mb from the 850 mb build through May, while a 520 mb build in product stocks will likely stay unchanged.

With demand growth stalling, our model suggests the margin for error is becoming increasingly thin in 4Q’20, with a resulting implication being that OPEC+ might be facing another decision around October.

Despite accumulating evidence that physical market fundamentals are getting shakier, prompt oil prices have so far proved resilient with futures in New York and London trading above $40/bbl throughout July. In fact, the main factor contributing to our price forecast model miss in July has been the substantially weaker-than expected US dollar. The second factor was the tighter than- envisioned balance in July, with deeper and more extensive cuts in crude production driving an average 3Q deficit of 1.4 mbd vs a previous forecast for a 900 mbd deficit back when we last struck our price forecast in early June. Accordingly, we mark to market our 3Q price forecast to $41/bbl for Brent.

However, physical oil markets continue to face fundamental headwinds and we now see the global market averaging only 1.3 mbd deficit in 4Q’20 vs. our previous forecast of a 2.6 mbd shortage. Despite this weaker fundamental outlook we still think prices will find support around $40/bbl given the breakeven calculus (and ensuing reaction function) of OPEC+ detailed above. We opt to keep our 4Q’20 Brent forecast unchanged at $41/bbl.

Hence, we advocate shorts in Brent futures of August’20 delivery, simultaneously, short hedges of September tenors. Thereby, one can ensure directional positions amid macroeconomic and pandemic turmoil. Courtesy: JPM

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