JPMorgan warns: If the oil market is to ultimately clear, it will trigger a price surge far beyond expectations.

The oil market's current most bizarre aspect is the discrepancy in accounts: a large portion of supply has been taken away, inventories are rapidly shrinking, demand is also declining, but the price's reaction does not resemble that of a market undergoing forced liquidation. JPMorgan's conclusion is straightforward - there is something wrong with this global oil supply-demand equation. JPMorgan's commodities strategist Natasha Kaneva wrote in a recent research report, "From a practical operational perspective, oil prices must rise much higher." Her logic is that the physical commodity market ultimately has to return to equilibrium: when idle capacity is insufficient, inventories thin out, the only way to reduce consumption is through higher prices, forcing the market to clear. The report presents several key figures: global supply disruptions were 9.1mbd (million barrels per day) in March and expanded to 13.7mbd in April; observable commercial and strategic inventories were drawn down at rates of 4.0mbd and 7.1mbd per day, respectively; global oil demand fell by 2.8mbd per day in March and has tracked a decline of 4.3mbd so far in April. The issue is that despite this, Brent futures prices are still below $100 per barrel, and this rate of demand decline resembles more of a "having to use less" scenario rather than a logical price-demand pressure. The conclusion drawn is that the gap needs to be closed, and it cannot rely solely on the Middle East, Asian economies on the periphery, and Africa to carry the burden. JPMorgan believes that Europe and the US will also need to be pulled into this rebalancing with higher oil prices. Cracks have already appeared on the product side: petrochemical feedstock and aviation fuel are contracting first, gasoline seems more resilient, but this buffer may not hold up until peak season. The gap is too large to clear at current prices The starting point of the report is physical constraints: oil has to balance its accounts every day. When supply is reduced, the market first looks to idle capacity to make up for it; if that is not enough, then only inventories can be used; as inventories tighten, prices have to rise until demand is forced to a level where "oil is available to buy." Kaneva's statement of "the math not adding up" lies in the fact that the amount removed from the supply side is too large, and the combined visible inventory drawdown and demand decline are still not enough to completely close the gap. As long as the gap remains, prices will only be pushed to a level where the market clears. Idle capacity as a buffer has failed Normally, idle capacity is the oil market's biggest buffer. This time, it failed distinctly: almost all idle capacity is concentrated in Saudi Arabia and the UAE, and under the current shock, this part of the capacity has effectively been cut off from the global market's supply capability. The US, as a marginal supplier, cannot rescue the situation. Even if oil prices rise significantly, meaningful increments of shale oil usually take 3 to 6 months to materialize, and within that window, they can likely only contribute 0.3 to 0.7mbd; larger increments typically take longer, extending to 6 to 12 months. Russia still has about 300kbd of idle capacity, but recent attacks on its energy infrastructure have reduced supply by 350kbd, making repairs more difficult. The correction mechanism on the supply side is stuck, leaving the market to rely more heavily and earlier on inventory drawdowns and demand compression. Inventories are being drawn down faster, and the visibility is lacking After idle capacity is insufficient, inventories are forced into action. JPMorgan estimates that in March, observable inventory drawdowns averaged 4.0mbd per day, accelerating to 7.1mbd in April - the effort to bridge the gap through inventory is significantly increasing. What's even more troublesome is the lack of visibility. The report warns that the market cannot see all inventories, especially with a poorer transparency of finished product inventories, the actual depletion of inventories may be higher than reported. As inventories approach their operating limits, the task of prices becomes more singular: push them high enough to force consumers to give up barrels. Demand is declining, but not necessarily because "it's too expensive to afford" The research report compares the demand decline to the financial crisis: in January 2009, the peak global demand dropped by about 2.5mbd, while this time it reached 2.8mbd in March, expanding to 4.3mbd so far in April. The strangeness lies in the prices - Brent futures prices in March and April were both below $100 per barrel, while spot crude oil prices in March were around $107 and in April around $123; although refined oil prices have almost doubled, it is hard to explain such a significant demand decline in such a short time solely based on prices. The report offers a firmer explanation: a significant portion of the apparent "demand destruction" is actually a reflection of supply shortages hitting the demand side - the shortages limit actual consumption, so consumers unable to purchase oil can only reduce their usage. Middle East, Asian economies on the periphery, and Africa have borne 87% If the main reason for demand contraction is being unable to purchase, the focus shifts to who is unable to purchase first. The adjustments so far have mainly focused on the Middle East, Asian peripheral economies, and secondarily on Africa; the former is at the center of the shock, while the latter heavily relies on Gulf oil and refined oil, with thin inventories and weak fiscal buffers. When the flow of goods is redirected to markets offering higher prices, some buyers are directly pushed out of the market. JPMorgan estimates that these regions contributed 87% of the 4.3mbd demand decline in April. Rebalancing cannot solely rely on these regions reducing consumption in the long term; the gap will be pushed towards larger consumption areas. To close the gap, Europe and the US must also participate The report brings the issue back to arithmetic: around 14mbd of supply has been removed, and even under the extreme assumption of "8mbd of inventory drawdown per day", the market still needs an additional 2mbd of demand decline to clear. This magnitude cannot be absorbed solely by emerging markets; Europe and the US need to participate in rebalancing. For these two major consumption areas to see a significant reduction in demand, prices need to rise. Europe has already begun tightening, with diesel and jet fuel already tight, disruptions in supply further squeezing availability of middle distillate oil; the short-term isolation in America, with better domestic supply elasticity and inventory buffers, is already beginning to suppress discretionary driving demand, and increased airfare prices are softening demand for jet fuel. Product sectors are first to crack: petrochemicals and jet fuel closures, gasoline buffer fading The first to be affected are sectors with thin margins and price sensitivity. Gulf LPG, ethane, and naphtha shortages have forced several PDH and steam cracking units in Asia to reduce or stop production. LPG is an important civilian fuel in India, where LPG consumption in March dropped by 13% year-on-year. JPMorgan estimates that weaknesses related to petrochemical feedstocks account for approximately 55% of the 4.3mbd demand loss in April; jet fuel accounts for 11%, mainly due to the evaporating demand from flights being grounded in the Middle East. The contraction of aviation activity in Asia and Europe in May will further weaken the demand for jet fuel. On the gasoline side, due to less reliance on Gulf supply, gasoline price increases have been lower than middle distillates so far, but this isolation may not last long: refinery constraints tightening, a broader spectrum of refined oil balance being stressed, combined with the seasonal demand spike for summer driving in the US, gasoline will eventually be pulled into the same tightening net.