Market Monitor

Managing COVID-19: China, OPEC and the energy markets

The coronavirus epidemic has put Asian oil and gas demand growth back in the spotlight – this time as a spoiler not the savior it has been in the last three decades.  That period had its scares – the Asian financial crisis of 1997-98 and the global financial crisis of 2008-09 – but Asian demand could generally be relied upon to buoy growth and bounce back quickly after crises. In the wake of COVID-19, forecasts of an economic rebound in China by mid-year may be correct, but certain structural factors could alter the longer-term trajectory of demand growth. For OPEC and the oil markets, the conditions make for an uncertain 2020.

 

A sluggish return to health for China?

The effects of the COVID-19 outbreak on China’s economic health may be felt way beyond the current slowdown. Trade frictions, and changing manufacturing patterns and investment flows resulting from, or exacerbated by, the virus are expected to have longer-term structural implications for the overall economy.

Nonetheless, short-term cyclical factors related to the virus will be the main drivers of declining demand and lead to a V-shaped demand curve or at worst a U-shaped one.  This has implications for OPEC and the world oil markets: the short-term market conditions have worsened what portended to be a lousy year for OPEC anyway and will require even more “heroic” efforts to balance supply and demand.

Optimistic forecasts from most analysts of a V-shaped curve denoting a collapse in demand in the short run (one quarter at worst) and then a quick recovery by mid-year may not transpire.

This is due to several factors: Municipal and county governments in China and industry regulators have been selective in allowing business restarts after the New Year holiday period and require case-by-case applications and approvals. What are deemed as non-essential businesses have not been allowed to resume operations.  Quarantine requirements could further postpone the actual start date of work.  Moreover, the government requires all employees returning to work to wear a facemask, but a severe shortage in medical supplies could prevent most companies from obtaining necessary gear.

Chinese firms, especially in the private sector, have been struggling with high debt levels and complications from US tariffs.  Moreover, for some industries and companies that were already strained by increasing costs related to environmental protection and tax compliance, the COVID-19 epidemic may be the last straw that breaks the camel’s back.

Even after the resumption of the operations, their energy demand and ability to pay could be undermined.  Therefore, these factors could create systemic problems as one blockage in the supply or sales chain could disrupt the normal operations of entire industries and prevent a quick start-up.

 

Complications for full recovery

Even if the markets get lucky and there is a quick rebound, some structural factors lurking in the background could change the longer-term trajectory of Chinese and Asian demand growth.  Since the beginning of US President Donald Trump’s term, one factor already playing out in the Chinese economy is the US-China trade war.  In reaction, many global manufacturers have been questioning the integrity of their supply chains linked to China due to the trade tensions.  Out of prudence, some had already started to diversify sources of output.

COVID-19 intensified the focus on global production concentration in China and the possible disruption it will cause.  Consequently, fears of another trade-related dislocation could accelerate the diversification of manufacturing centers globally and regionally, and lead to a slowing of foreign direct investment into China.  Even Chinese companies seeking to assure foreign customers of their ability to offer supply optionality could move to other countries such as Vietnam, Indonesia or even closer to the US and invest in Mexico.  These factors will exacerbate the manufacturing slowdown in China and all it means for long-term energy demand.

 

What will OPEC do?

Whatever the prospects for China’s long-term economic recovery, short-term declines in oil consumption will force OPEC to make drastic cuts. According to the oil-demand forecasts of China-focused consultancy SIA Energy, demand for crude oil will be 1.2m barrels per day (bpd) lower year-on-year in the first quarter of 2020.

SIA Energy’s base forecast expects a rapid economic rebound in China due to the replenishment of industrial inventories and the government’s economic stimulus. However, it cautions that physical disruption due to people movements may render government stimulus measures much less effective.

Barring that, a rebounding economy and a supply push from new integrated refineries (those with petrochemical complexes) and lower energy prices will help revive weak demand.

Under these circumstances the crude oil consumption forecast in 2020 has been cut by 120 thousand barrels to 13.92m bpd.  Full-year demand growth is projected at 360 thousand bpd, or 2.6%. This compares to at least 5% growth per annum in 2011-19.

To balance the markets, OPEC must deal with two management issues – the pre-virus declines in the “Call on OPEC,”[1] due to slower demand conditions and output increases from the US, Brazil and Norway; and post-virus declines in Chinese demand.

 

OPEC market management:  pre- and post-virus

 

In line with slowing demand from China in the first quarter, the Call on OPEC is expected to fall by 1.5m bpd. OPEC had planned to cut 1.25m bpd the first quarter before the virus struck – now it will have to cut 2.7m bpd.

However, the bounce back of demand forecasted in the rest of the year leads to OPEC needing to cut progressively less. By the fourth quarter, in both pre-virus and post-virus scenarios, OPEC can increase production compared to Oct-Nov 2019, and more so in the post-virus scenario.  Saudi Arabia is assumed to bear the brunt of output reduction, although other countries, notably Iraq, the UAE and Kuwait, will share some of the burden.

On an annual average basis, the coronavirus will have virtually no impact on OPEC’s output even though in the first quarter of 2020 the impact is quite pronounced. It is going to be a very uncertain year for OPEC and the market, with all that implies for price volatility.

 

Fareed Mohamedi is an international political economist specialising in the geopolitics of energy and energy markets with a special emphasis on the economic development of petrostates and their foreign relations. He has led research teams in several specialised energy consultancies and two national oil companies. He has worked as a macro-economist with economic research institutes in Washington DC, a bond rating agency in New York City and the finance ministry of Bahrain. Fareed is currently Managing Director of SIA-Energy International, the global division of SIA-Energy based in Beijing.


Sources:
[1] Call on OPEC: the estimated production volume required to balance global markets

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