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  1. Home
  2. / Investing
  3. / Energy

Europe Announces Travel Restrictions Over the Weekend - Oil Oops!

We know that the extra oil is coming, it is just a matter of when not if. The big question is demand.
By MALEEHA BENGALI
Dec 21, 2020 | 10:45 AM EST

Brent Oil price has rallied from $38/bbl. back in November up to $52/bbl., a gain of 37% in over a month and a bit! One could argue it was too cheap below $40/bbl. and now perhaps too expensive above $50/bbl. Oil has been one of the worst trending Commodities this year as it got hit the hardest given ample supplies available earlier in the year when the world went into lockdown. In November following news of the vaccine discovery, it was one of the first to rally as hopes emerged of people being able to travel and move freely, the world returning to some form of normalcy as and when the population would be vaccinated. Of course, things take time, but the Oil market rushed to price in the recovery optimism at the onset. Traders cover first, ask questions later. Especially when everyone is underweight.

One of the only reasons why the Oil price has held up so well despite demand not recovering back to pre-Covid levels is because the OPEC+ group (namely Saudi Arabia and Russia) have convinced members to keep 7.7 mbpd of Oil out of the market over the past few months. This, they thought, would buy them enough time to then release the extra barrels once demand, or the world, "normalized". As prices have rallied over $50/bbl., most members are now itching to release their held production and optimize on Oil sales. We know that the extra Oil is coming, it is just a matter of when not if. The big question is demand. Demand in China and India, pretty much the East, has been very strong. This has been offset by demand declines in the U.S. and Europe, and the West. Whilst life in the East seems almost back to normal, the West is grappling with more and more cases, high hospitalizations, and deaths. We are at a place where all the positive news is being priced in by the Oil market, everyone willing to look past the next 3-4 months, assuming 100% take up of the vaccine, coronavirus disappearing and all countries opening their borders, and the world returning back to normal. But the fight is far from over as we still have the next two quarters to get through.

Commodities are all about inventory balances, prices can only move so far till demand meets supply. If the latter is just too much, price will stay constant at best or fall with the weight as this is a physically settled instrument. It seemed the market priced in no risks at all or any shocks to the system. Over the weekend, the UK announced a new strain of the virus and is worried about a deadlier wave two, so is limiting travel in and out of the country. Most EU countries like Italy, Ireland and Switzerland have also cut flights from the UK coming in. Essentially right before Brexit, the UK is getting boxed in. Less flights mean less jet fuel demand, which has been one of the slowest products to recover. Gasoline, after bouncing off the summer lows, has once again fallen short. Either way total product demand is nowhere close to pre-Covid levels and inventory is quite ample. China is buying Commodities but that demand is not able to offset the declines seen elsewhere in Oil.

From a pure top down perspective, there is clearly a rational to own hard assets like Commodities. But initially a rising tide can lift all boats, but at some point, fundamentals take over capping those with the weakest inventory balances (Oil) and rallying those with the tightest (Copper and Iron ore). When an asset lags, there is usually a reason for it. Sure, a case can be made for owning Oil towards 2H21 if all goes well. Most investors say they are willing to own an asset looking past any near-term volatility, but when the asset falls 20%+, they panic and run for the hills.

For now, Oil seems like it is at best capped, with risk of more severe lockdowns in U.S. and EU posing downside risks. If one is allocating capital to Commodities, it pays to direct it to the ones that have the least supply in a rising demand environment, and not where producers are waiting to flood the market with more of it as prices rise, especially after these stocks have moved 50%+ already post every sell-side house upgrading them after the fact, of course.

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At the time of publication, Maleeha Bengali had no position in the securities mentioned.

TAGS: Commodities | Investing | Markets | Oil | Stocks | Trading | Energy

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