Unknowable Energy Demand Challenges Oil Price Outlook
“The oil industry planning cycle is underway and an important ingredient for forecasting revenues is predicting oil prices. It requires an assumption about what demand will be once we are past the worst of Covid-19. ”
Everyone wants to know when we are going to return to normal, especially as it relates to energy demand. The problem is that we have no idea what normal will look like. The Wall Street Journal’s Heard on the Street column recently had an article entitled: ‘Normal’ After Covid: More Suburban Sprawl, Fewer Business Trips.’ The headline was designed to capture two of the more noticeable trends of 2020 that came from dealing with the coronavirus outbreak. Those include people migrating from populated areas to less-populated ones offering larger homes that enable people in lockdowns more room to roam without having to go outside and encounter potential virus spreaders. The idea of fewer business trips encapsulates the dramatic changes underway within the business world as companies learn to operate with most, if not all, employees working remotely. Zoom or Teams calls are replacing the business trip and customer interactions that characterized the business world for centuries, such as why Marco Polo went to China. He went with his merchant father and uncle on their second trip to China both to learn about the country, its people, its religions and its leaders, but also about its commerce, as they wanted to do more business. It is all chronicled in The Travels of Marco Polo.
With the development of two Covid-19 vaccines and the possibility that enough Americans should be inoculated next spring and summer for normal life to return, the writer opines that “it won’t be quite the same as before.” The writer declares: “Our behavior will have changed, with profound effects on the economy.” That statement highlights the challenge facing every forecaster of social and economic trends – just how different will our lives and business activities be once government restraints are released? Assuming that how we live and work today will become the “new norm” is just as wrong as assuming we will return to the pre-Covid-19 world. What is unknown is which new behaviors will prevail and which ones will be rejected in favor of how we “used to do it.”
One thing we can count on is that every forecast will prove wrong – but just in what ways and by how much? Examining assumptions going into forecasts will actually become de rigueur. In the meantime, energy executives must begin planning for the future – which starts with 2021. The current surge in Covid-19 cases has the world on edge, as they will impact the foundation and context shaping forecasts. Countries, states and cities are resorting to greater restrictions on citizen activities, much to the consternation of the many who are tiring of being harnessed to their homes and told not to go to work or travel. With vaccines not arriving until December, and health workers and first responders receiving the initial doses, an economic downturn this winter due to uncontrolled virus outbreaks appears to be a given. The uncertainty over when a significant number of people will be vaccinated in 2021 makespredicting the pace of economic activity next year a guess. Understanding the semi-permanent behavioral changes, and guessing which ones will become permanent, will shape the long-term outlooks of oil forecasters.
As energy is the economy, i.e., nothing happens in our lives or businesses without the use of some form of energy, we need to start with an assessment of the activity outlook posited by economists. The current word being used to describe economic conditions this winter is “dark.” It is a term that conveys a future with increased fear and emotional stress, greater suffering, losses of jobs and incomes, heightened restrictions on mobility, and generally a miserable environment. That is not a positive outlook for the economy. In fact, JPMorgan economists have recently suggested that the U.S. economy will experience a 1% contraction in 2021’s first quarter. But, as they assume there will be meaningful stimulus spending injected into the economy in January by the new Biden administration and Congress, the economists expect a robust recovery in economic activity, as demonstrated by their projections of +4.5%, +6.5% and +3.8% quarterly increases in GDP for the balance of 2021.
Bill Gilmer, director of the Institute for Regional Forecasting at UH’s Bauer College of Business, recently forecast that Houston will remain in a moderate recession throughout next year. A reason why is due to his expectation that oil prices will only average $48.50 in 2021 and won’t return to an “activity-driving” $60 a barrel price until the second half of 2022. Here is a good example of understanding the assumptions going into the forecast.
The JPMorgan economists pointed out that “[b]y a wide margin, the course of the virus has been the most important factor shaping the outlook.” With increased headwinds from the current uptick in virus cases, they believe holiday spending will be hurt. They went on to say:
“We think the trends in the labor market should roughly follow what we expect for consumer spending – job growth should weaken noticeably around the turn of the year as the virus weighs on the economy, and then pick up again early next year once vaccine distribution eases virus concerns and fiscal support boosts growth.”
A different view on how economic activity might unfold in 2021 was presented in the following chart. Since the two vaccines that have been developed so far have efficacy rates in excess of 90%, one should be looking at healthy quarterly growth rates early in 2021, especially as the launch date for the vaccines is December.
Exhibit 1. How GDP Growth Is Impacted By The Vaccine SOURCE: John Mauldin
If the JPMorgan economists’ forecasts prove correct, energy demand should be looking at a healthy growth rate next year, after stumbling out of the gate in the first quarter. The weakest sector will be air transportation, as business travel and vacations will be slow to recover. Overall, however, we believe this outlook suggests 2021 oil demand slightly trailing its pre-Covid-19 level, despite a healthy increase in GDP. It is helpful to understand how the relationship between GDP growth and oil demand increases has weakened in recent times. We are not sure it is because of a structural change, but rather due to the aging demographics of the two largest oil consuming regions – the United States and Western Europe – and its impact on oil consumption. High oil prices may have also contributed to the slowdown in oil consumption, but that is rather a reflection of the move to more efficient use of energy.
Exhibit 2. Relationship Between GDP and Oil Demand SOURCE: EIA, World Bank, PPHB
When the economy was shut down in early 2020, oil demand and prices collapsed. Along with those declines went oil and gas industry capital spending. That means there have been substantially fewer new wells drilled and completed in 2020, leaving production to the vicissitudes of natural declines in the output of producing wells, which is not offset with new wells, as traditionally occurs.
To moderate and eventually reverse the decline in U.S. oil production will take a significant recovery in oil and gas spending and activity. Such a recovery will not happen quickly, as the response to the decimation of the industry in the spring, and the longer-term deterioration in demand that had become evident in 2019, forced companies to slash employment. The lack of revenues for service companies meant prioritizing spending away from equipment maintenance. Thus, it is safe to say that the oilfield services industry’s capacity to respond to higher activity levels has been impaired. How quickly it can be repaired is questionable.
As we think about future oil demand, we wonder what history may tell us about the relationship between oil consumption and economic activity during recessions and the months immediately after their endings. The current recession is not a typical one, as it was caused by government mandates shutting down activity to deal with a health emergency. Therefore, its recovery is also tied to government actions, the timing of which are uncertain, and often unpredictable.
In a recent article, investment advisor John Mauldin wrote about the challenge our economy had in returning to normal, a condition he has yet to fully describe. He presented a chart showing job losses and recoveries from recessions of the past 40 years. In making his point that the recovery will take time, he wrote the following:
“It is unrealistic to assume we will go back to some kind of “normal” in 2021. I think even 2022 will be a stretch. We have had a massive and severe blow to our economy. The chart below from the Center on Budget and Policy Priorities shows how it took four years to recover from the 2001 recession in terms of jobs and over six years for the Great Recession. The current recession is much worse than either of those.”
Exhibit 3. How Our Recent Recessions Developed SOURCE: John Mauldin
Jobs are a measure of the health of the economy. In April, when Covid-19 was raging in various regions of the U.S. and states were locking down their economies, American job losses exceeded 20 million that month, sending the unemployment rate skyrocketing to 14.7% and the U6 rate (unemployed plus underemployed workers) reached 22%. Since then, we have recovered more than half the jobs lost and the unemployment rate in October was down to 6.9%. With the rising virus cases, people are now worried that unemployment will begin climbing as governments institute a new round of economic lockdowns and curtailed activity. Weekly job losses are not declining, and often ticking up. The lockdowns and behavioral changes to the economy have people wondering what it means for employment, and, in turn, inflation. Spencer Hill, an economist at investment firm Goldman Sachs, in a recent report, said he doesn’t expect the labor market to recover until 2024, which he believes will hold down inflation. But that outlook doesn’t bode well for economic activity and energy consumption.
Using the chart from the Mauldin newsletter, we began examining this recession compared to the prior four recessions. All five recessions are displayed in Exhibit 4 that shows the percentage change by month from the start of the recession until it returned to 100%. In the legend accompanying the chart, we show the official dates for the recessions as determined by the National Bureau of Economic Research (NBER). For 2020, NBER has only announced the starting date for the recession, although many people have speculated that this might be one of the shortest U.S. recessions in history. What is of significance in this chart is the length of time each recession needed to return to the same employment level as when the recession started. For example, the December 2007 to June 2009 recession, actually didn’t see a return to the same employment level until May 2014, almost exactly five years later.
Exhibit 4. Recessions And Nonfarm Employment Recoveries SOURCE: St. Louis Reserve Bank, PPHB
While everyone acknowledges that the 2020 recession is not like any prior recession, they are still using comparisons to those earlier ones in their discussions. One of the amazing economic stories of 2020, besides the destruction of the energy business, has been the strength of the housing sector. While some of its strength is assumed to be due to the virus – people wanting more room and homes outside of urban settings – analysts continue to marvel at the record-setting performance of new housing starts. Using that data series, we compared absolute monthly start data to the changes in nonfarm employment. Because the government didn’t begin to report housing starts until the latter 1980s, we don’t have a measure of how starts compared to employment changes during the 1981 recession.
Exhibit 5. How Employment And Housing Starts Tracked SOURCE: St. Louis Federal Reserve Bank, PPHB
What we see in the chart is that for every recession other than the 2007 recession, after an initial dip, there developed a steady upward trend in housing starts. The trend in housing starts in 2020 mirrors just as dramatically the decline and improvement in nonfarm employment. Only the 2007-2009 recession never saw housing starts recover to the level at the start of the recession. While some would suggest that this recession was caused by excesses within the housing industry – financing of homes – so it should not be a surprise that housing would suffer. With growth of population and employed people, besides the increase in the younger population just graduating from universities, it is hard to accept that housing starts would remain well below were they were at the start of the recession seven years earlier.
We struggled to find any other economic measures that offered much insight to overall economic activity. As a result, we turned our attention to the oil market. This produced some interesting results. The 1981 and 1990 recessions saw virtually no impact on oil prices – up or down! The 2001 recession did see oil prices rising as the economy was recovering, but one has to wonder how much of the price rise was due to the emergence of China as an oil consumer, especially as the country was revamping its infrastructure in preparation for the upcoming Olympic Games, and the emergence of the country on the world stage.
When we examined what happened to oil prices during the Great Recession of 2007-2009, we see that oil prices continued rising during the early months of the recession, but they then collapsed as the recession’s impact became clearer. The recession’s primary impact was a financial liquidity scare that froze global financial and currency markets. Without credit, global trade and economic activity slowed, but the bigger issue for energy companies was that the lack of assured access to capital caused producers to pull back their spending, which forced a significant reduction in oilfield activity. The fear of a global financial crisis and recession caused a sharp fall in oil prices. Despite the economic turmoil, oil prices quickly recovered once credit market conditions improved. The recovery was driven partly by the shale revolution and expectations that substantially more oil output was going to be required to satisfy global needs, especially with recurring fears of impending peak oil supply.
The current recession has seen oil prices collapse along with global oil demand. In fact, oil prices briefly traded at negative prices in reaction to market turmoil, which eventually proved to have been overblown. As economic activity rebounded once the lockdowns were eased, crude oil prices also rebounded. Once they reached the $40 a barrel level, the price advance essentially stopped, and prices became more volatile in a range of $37 to $43 per barrel. Prices appeared to move in direct response to daily news about the development of Covid-19 vaccines.
Exhibit 6. Nonfarm Employment And Oil Price Trends SOURCE: St. Louis Federal Reserve Bank, PPHB
The most telling analysis is the comparison of nonfarm employment and oil consumption. Excluding the 2020 recession, which is not over yet, only the 2007-2009 Great Recession did not see oil use, measured with a three-month average, rise above its starting point by the date of the full recovery of nonfarm employment. Was the failure of the Great Recession to reach a new high a function of oil’s extremely high price, or due to structural problems with the U.S. economy?
Exhibit 7. How Employment Changes Impacted Oil Use SOURCE: St. Louis Federal Reserve Bank, EIA, PPHB
While U.S. nonfarm employment has recovered slightly more than half of what it lost this spring when economic lockdowns began, oil use is 10% below where it was in February when the recession began. Although U.S. oil consumption is important for producers, price-setting is impacted by the overall health of the global oil market. Therefore, government responses to the virus are key drivers of demand.
Most oil forecasters by October had essentially fine-tuned their 2020 estimates, noting their cautiousness about predicting the impact of the new virus outbreaks on oil demand.About ten days ago, the members of the market monitoring committee of OPEC held a meeting at which they revised their 2020 demand forecast to reflect a decline of 9.8 million barrels per day (mmb/d).This was a further 300,000 barrels per day reduction from the organization’s October 2020 demand estimate.From OPEC’s original expectation for demand in 2020, the new estate suggests an 11 mmb/d cut.We compare that estimate with the September forecast from energy consultant Rystad Energy that shows a 10.2 mmb/d decline in oil use this year.The firm recently said that it does not expect global oil demand to return to pre-Covid-19 levels until sometime in 2023.
Moreover, the firm has just revised its long-term outlook for oil demand. It now suggests that peak oil consumption will be reached in 2028 when oil use reaches 102 mmb/d. That forecast is lower and sooner than its prior outlook, which saw the oil demand peak of 106 mmb/d not being reached until 2030.
Exhibit 8. How One Oil Forecaster Sees Oil Recovery SOURCE: Rystad Energy, PPHB
Another long-term forecast made earlier this year came from the Energy Information Administration (EIA) in their revisit to the agency’s Annual Forecast. Factoring in assumptions about how Covid-19 would impact behavioral patterns and the economy’s use of oil, the EIA expects demand will fall 2.3 mmb/d below where it would have been in 2025 without the virus. The EIA sees that shortfall from its prior forecast continuing and growing over time, such that by 2030 the shortfall is 2.9 mmb/d, and then lower by 6.1 mmb/d in 2040 and 12.8 mmb/d in 2050. What is interesting is if we compare the EIA and Rystad estimates, assuming the latter’s revised demand peak is for 2030. The difference between 4 and 3 mmb/d is, as they say, close enough for horseshoes, hand grenades and government forecasts.
Exhibit 9. How Covid-19 Virus May Hurt Oil Demand SOURCE: EIA, PPHB
A presentation by international energy policy expert Robert McNally, founder of The Rapidan Group, a Washington, D.C. energy consulting firm, at the recent energy conference sponsored by the Federal Reserve Banks of Dallas and Kansas City, suggests a vastly different future for energy markets and oil prices than assumed in the consensus view of forecasters. His outlook is supported by oil market news stories pointing out the dichotomy in global oil markets between the East and West regions of the globe. In fact, understanding this dichotomy may prove to be much more important in projecting energy’s long-term future than many people appreciate.
Mr. McNally’s presentation focused on three topics: Peak Oil Demand – realistic or wishful thinking; Geopolitical Disruption Risk; and Swing Producers – do we have them or need them? Rapidan’s view is that oil demand in Asia (the East) over the next few years will prove much stronger than forecasters are incorporating in their models, translating into a greater overall global demand increase, which will power a faster oil market recovery. Such a recovery will, in Mr. McNally’s opinion, quickly exhaust the industry’s current spare supply capacity, even after factoring in the return to the global oil market of the roughly 2 mmb/d of Iranian oil supply. The result will be oil prices rising substantially higher by the mid-2020s than oil companies and forecasters anticipate. He believes too many people are accepting of the conventional view, expounded by the International Energy Agency (IEA), that demand growth will be historically low, the world has plenty of spare oil production capacity and therefore oil prices will remain low. Shaping this view is the IEA’s belief in the success of countries shifting away from fossil fuels and embracing renewables. In his view, the scenario he outlined will lead to the next oil industry bust, which will speed the global switch to renewables, but not before.
The evidence for Mr. McNally’s scenario is Saudi Arabia raising oil prices for its Asian customers. In addition, The Wall Street Journal noted that Dubai crude oil is now selling at a premium to dated Brent (Atlantic basin oil) prices in contrast to having sold at meaningful discounts throughout 2018 and 2019. Tom Tom data shows multiple Asian cities showing year-over-year congestion increases.
As Amrita Sen, founder of Energy Aspects Ltd., a consulting firm, told the WSJ, “I can’t remember this level of disparity between the East and the West.” He went on to say, “Yes, the West is going to recover a bit, but I really don’t think Western demand is going to get back to pre-Covid levels ever, whereas the East already has.”
Mr. McNally recognizes that the future oil market will be different, and, importantly, driven by other considerations than what has propelled it throughout its history. The United States and Western Europe are mature oil markets, but they are large consumers. Without them, the global oil market would be a fraction of the size of what it currently is. Their contraction will impact global oil demand.
How will a U.S. oil industry unable to secure capital, and which is maligned by the incoming administration and the media, be able to sustain its economic importance? As a result, how much smaller will the industry become? Will the need for greater U.S. oil imports come at the same time Asian economies are sucking up the available supply? This will lead to much higher oil prices. But importantly, every time in the past, high oil prices sowed the seeds of industry’s destruction. Maybe we can enjoy higher oil prices, while figuring out how to avoid the industry’s destruction.