Via Westpac:

A global pandemic crushes resources demand, particulary for but not limited to, crude oil

Our review of the COVID–19 pandemic and its impact on economic activity resulted in significant revisions to our global growth forecasts with a deepening recession in the global economy. Westpac is now forecasting a 1.5% contraction in world output for 2020, with the G3 declining by 6.8%. With an expected similar contraction in industrial production this represents a significant destruction of demand for resources, particularly for energy. On the supply side, disruptions to date have been more mixed between commodities. Our thoughts on the outlook for the key economies have been detailed in the April Market Outlook and flow directly into the revisions made to our commodity forecasts. Lower crude prices are a significant deflationary shock.

The most significant revision has been for crude oil. Our Brent forecast for June has been lowered by US$35/bbl to $30/bbl and the year-end forecast is now 36% lower at U$32/bbl (it was US$50bbl). This weaker demand for energy, and falling crude prices, has also seen us revised down our LNG forecast for year–end by 24% to US$4.1/mmbtu. Base metals have weakened further, particularly aluminium but also copper and nickel. Our June forecast for the base metals index is 8% lower at 120 and we expect it to hold around these levels to year end. Our previous forecast was for it hold around 131 to year end.

It is also important to remember that declining crude prices are a significant deflationary shock. Not just for consumer prices but also for the input costs for many industries including resources. As such, falling crude prices have significantly lowered production costs for many commodities, and in turn, lowered average break even prices. This will support resources production at lower prices helping to lock in the new lower prices. For met coal producers it could represent a cost saving of US$10 to US$17/t. The cost savings for iron ore producers is around US$7/t (estimates by Wood Mackenzie).

In regards to the bulks, we have left our iron ore viewunchanged at US$65/t by year end but the surge in Australian exports through March gives us less confidence that a recovery in Chinese demand will be enough to sustain prices through the next few months and have marked down end June to US$50/t. Qld coking coal eased in the month, now down to US$126 from US$146 in March, and we have lowered our end 2020 forecast to US$127 (was US$130). Meanwhile thermal coal is holding US$70/t and we expect it to hold this level to end June before moderating to US$65 by end 2020. All up by end 2020 our broad commodities index forecast is now 5% lower than we forecast in March, an 11% fall from its current level. 

Russia and Saudi Arabia agree to a truce, but not soon enough to prevent a massive Q2 oversupply in crude

As noted earlier, we have cut our crude oil price forecasts. This reflects the significant hit to demand from COVID–19 and the earlier breakdown of OPEC+ negotiations. While demand shocks and supply shocks are common in the crude oil market, a combination of both is very unusual. The surprising collapse of the OPEC+ made for a significant dual shock unprecedented in modern history. Since the publication of the April Market Outlook OPEC+ has come to an agreement to cut output by 10mbpd from May to June, the largest cut to production in OPEC history. It is also been agreed that production will remain constrained for the next two years, albeit less strictly than it will be for the near term. In addition the G20 oil producers have announced that their production will be about 5mbpd lower this year.

The agreement doesn’t, however, change the near-term imbalance driven by a sudden sharp drop in demand. It has been estimated that demand collapsed by 20mbpd in April and the OPEC+ cuts are not due to be implemented until May. And the G20 announcement is not so much a government mandated production cut but rather how much output will be down this year given lower prices. As such the announcement won’t halt the near term surge in crude inventories quite possibly driving some crude storage facility to capacity resulting in negative prices as producers have to offload production they can’t store. While the market initially took a favourable light to the announcement, we remain cautious that prices can go lower before they recover. 

The OPEC+ cuts will help to rebalance the market in the second half of the year, along a correction to US tight crude production due to the collapse in prices, but it is unlikely that energy demand will bounce back in the same way as it has in the past. With an increase in working from home, a reduction in domestic and international travel and the localisation of supply chains energy demand will be slower to respond to a lift in economic activity than it has in the past. In addition, while President Trump may highlight a longer term goal to reduce production by 20mbpd, this is an aspirational target that includes the G20 reduction in production OPEC has, in the past, struggled to maintain compliance to previous agreements. The President also claimed that a reduction in US production will offset any quota overshoot from Mexico. This would need the most pessimistic forecasts for US output to be realised and while there is scope to implement mandated production cuts (in Texas) it may be difficult to get all private US producers to agree and so such action is almost certain to face litigation.

We also see two other factors that will inhibit a rapid rise in prices. Higher prices will not only spur on greater non–OPEC supply, particularly from US shale producers, but it will also see Saudi Arabia and Russia remain focused on growing market share. Only in the last week while Saudi Arabia was negotiating the proposed cuts, they were still discounting crude into the Asian market The agreement represents a truce in the price war between Saudi Arabia and Russia but it is not an armistice.

Demand for imported iron ore remained robust as supply weakened – will the modest lift in demand be enough to soak up the lift in supply?

Demand for iron ore has clearly softened with the NBS estimating that Chinese crude steel output contracted 6.1% in the year to February. It has been reported that most of the adjustment came via higher cost electric arc furnaces (EAFs) with their utilisation rates falling to a low of 31% in late February. By contrast blast furnace utilisation never fell below 73% suggesting their output was more stable. This is important as blast furnaces used iron ore and higher grade met coal as feed stock while EAFs use more scrap steel and lower grade PCI coals. As such, the lift in Chinese production post COVID-19 will drive demand for scrap steel and PCI coal far more than it will drive the demand for iron ore and met coal. We are expecting an infrastructure led recovery to underpin demand and there are signs already of growth normalising with EAF utilisation rates back at 42%.

In addition, it is the expected lift in iron ore supply that presents the further risk to prices. Australian ore exports in February were significantly affected by tropical cyclone Damien in the first half of the month and the resulting drop in in February exports set the scene for a March correction. The bounce back was stronger than anticipated with Westpac’s preliminary forecast for March of 77mt, up 30%mth and 32%yr. However, supply out of Brazil has been more constrained, with combined Brazilian and Australian iron ore shipments just shy of 100mt in March and looking at Q1 overall, ore shipments are up just 1.5%yr highlighting weak Brazilian exports. Australian exports are estimated to be up 7%yr in Q1. This ongoing lift in Australian supply, aided by some further recovery in Brazilian exports, is key to softer ore prices through 2021. (see Australian March bulk exports – iron ore comes roaring back)

A shortage of Chinese met coal boosted demand for imports, that is now shifting

Coal prices, both met and thermal, had been well supported in early 2020 as Chinese coal shortages had been a feature of the COVID-19 impacts. Coal movements within China faced significant challenges throughout February, leading to falls in port and mill inventories supporting both import demand and domestic coal prices. But since mid-March coal production resumed at most mines sending capacity utilization rates at Chinese coal mines back to 2019 levels. This improvement in supply conditions triggered a modest downward correction in domestic coking coal prices which has since flown on spot seaborne prices. During February, ships anchored at Qinhuangdao port gradually declined to 8, an indication that demand is already weakening thus posing greater downside risks to coal prices. Globally blast furnace production is down significantly as steel production is reduced further reducing global demand for met coal. Give the deepening global recession, it in increasingly apparent that China alone can’t absorb the excess supply and prices are set to remain under pressure through Q2.