The oil price war is over and cuts promised, but be careful of the hype

These mega agreements, for all their flaws—and there are many—marks the end of the oil price war, but it doesn’t mark the end of the oil crisis as the production cuts are inflated and demand showing no sign of return soon

Scott McKnight – April 2020

By the end of Easter weekend, the war for oil market share was officially over. It took nearly a week of videoconferences between dozens of energy ministers and private calls between world leaders to reach an agreement that promises the largest ever coordinated reduction of oil output. The agreements also preserve the tenuous four-year-old alliance among producers known as ‘OPEC+’ while potentially launching a new era of oil diplomacy between the United States, Saudi Arabia and Russia.

In the end, the OPEC+ group willingly agreed to remove 9.7m barrels per day (bpd) or about 10% of world oil production from the global oil market, bringing Saudi energy minister Prince Abdulaziz bin Salman to declare that ‘OPEC+ is up, running and alive … I’m more than happy.’ On the other hand, the big oil producers outside the cartel also agreed to reduce production, albeit in a different way and with some accounting creativity may amount to another 10m bpd of potential production removed from the market. These mega agreements, for all their flaws—and there are many—marks the end of the oil price war, but it doesn’t mark the end of the oil crisis.

The oil market will be overwhelmed for months, as oil infrastructure—pipelines, terminals and storage—is filled or congested with little relief coming from economic activity, which remains paralyzed under coronavirus-inspired lockdowns and travel restrictions in many of the world’s biggest and most oil-hungry economies.

The cuts: hype and reality

We need to distinguish between voluntary and involuntary oil production cuts. The one that has captured headlines over this Easter weekend is of the voluntary or self-imposed nature. The Organization of Petroleum Exporting Countries (OPEC) and its ‘plus’ partners led by Russia agreed to deliberately remove 9.7m bpd from the market. The number is both large and captivating, but also misleading.

‘We have demonstrated that OPEC+ is up, running, and alive … I’m more than happy’ - Prince Abdulaziz bin Salman, Saudi Energy Minister

On the other end is the involuntary or market-driven cuts in oil production. This includes high-cost producers outside the OPEC+ arrangement, especially Canada, Brazil and the United States, the latter which has in recent years emerged as the world’s largest oil producer, a situation that this ongoing crisis will very likely end. In these countries, the oil industries are largely dominated by publicly traded oil companies of various sizes and specialties, and as such, have already begun a process of reducing drilling activity and closing wells due to weak oil demand and low oil prices.

Art of the deal

When Mexico’s left-leaning populist government threatened to detonate the mega-deal over refusing to cut a few hundred thousand barrels per day (here), President Trump intervened via tweet and phone call, accepting to shoulder some 300,000 bpd cut on Mexico’s behalf. There were several problems with this grandstanding high-profile act of generosity.

Mohammad Barkindo OPEC Secretary General delivers opening remarks to the 9th (Extraordinary) OPEC and non-OPEC Ministerial Meeting via webinar. Source: https://twitter.com/OPECSecretariat/status/1248286991105634308/photo/1

First, the US chief-executive doesn’t have jurisdiction to limit oil production; that falls to the states—or those like Texas and Oklahoma that have regulatory bodies in place to do such a thing. The other problem—and one far more relevant to these negotiations—was that those 300,000 ‘barrels’ of daily production from US wells that were now being sacrificed weren’t actually real but theoretical. These barrels would’ve never made it to production, conserved by a mix of low prices, anemic demand and lack of storage or transport capacity. The Saudis and Russians, under pressure from various corners, nevertheless went along with the theater, which, according to Annmarie Hordern of Bloomberg, both Washington, DC and Texas ‘the biggest winner’ of the Easter weekend agreement.

The oil price war is over

The mega-agreement, which centres around the compromise between Trump, Russian president Vladimir Putin and Saudi monarch Mohammed bin Salman, marks the formal end of the oil price war. At five weeks in duration, the oil price war didn’t last long; they rarely do, especially once the Saudis set their mind to adopt what Dag Harald Claes in his book on OPEC called ‘coercive hegemony’.

Prince Abdulaziz bin Salman Al-Saud, energy minister of Saudi Arabia (left); Alexander Novak, energy minister of Russia (right) at the start of an OPEC and NON-OPEC meeting in Vienna, Austria, December 6, 2019. Source: Reuters

The proximate cause of the war (here) started on March 6th in Vienna when Russian energy minister Alexander Novak rejected the Saudi output reduction proposal, including 500,000 bpd of Russian oil cuts, to counter what now is a laughably insufficient estimate for demand loss due to Covid-19, just as the spread of the coronavirus was manifesting itself in countries far from China.

The Russian refusal earned the wrath of the Saudis, which then adopted a shock-and-awe price war, featuring two tactics. First, Riyadh slashed its official selling price (OSP) by the largest margin in over three decades. These massive discounts on its crude led oil refiners to break from their suppliers and turn to buying Saudi crude. Second—and the tactic that caught the world’s attention—Saudi Aramco, the Kingdom’s national oil company, moved to tap all spare capacity and crank up production above 12m bpd.

Crude oil storage tanks at the oil refinery operated by Saudi Aramco in Ras Tanura, Saudi Arabia. Source: Bloomberg

Markets paid heed: the benchmark Brent crude fell off a cliff, falling more than 30% in value in seconds, the biggest single-day drop since the 1990-91 Gulf War. This production increase was a startling 25% over February volumes and enough to satisfy all oil demand in France, Germany, Japan, Italy, Spain and the United Kingdom. For much of March and early April, Saudi Aramco pumped every barrel it could and did so for resale with garage-sale discounts, inundating the oil market that was already in the midst of an unprecedented demand collapse of some 20-25m bpd.

The flood of oil also signaled the Kingdom’s intent to bring discipline back to the OPEC+ arrangement. The excessive use of its market force prompted oil-producing countries, many involved in the OPEC+ consortium, to take part in the videoconferences of Easter weekend.

The agreements reached after these marathon sessions features production cuts by Saudi Arabia and Russia and marks the end of ‘the most chaotic month in the oil market’s history’.

The crisis isn’t over

The promised cuts aren’t sufficient or accurate. The widely cited figure of 20m bpd, uncritically cited in the media and which Trump tweeted—are far overblown.

First, the OPEC+ cut is calculated on April’s inflated production baseline, including Saudi Arabia’s 25%-increase over February rates to 12.3m bpd. Second, this OPEC+ cut of nearly 10m bpd will come down to 8m bpd for the second half of 2020, but it remains to be seen whether economic activity—and thus oil demand—will have returned to levels resembling late 2019 or early 2020 before the widespread coronavirus-induced stoppages took effect.

Third, another accounting trick behind this figure of 9.7m bpd is some 2m bpd in output being cut from OPEC member-states that, for mostly political and economic reasons, weren’t able to produce to their capacity. Several of these countries, including Libya (civil war), Iran (sanctions, social unrest and coronavirus) and Venezuela (social unrest, sanctions and underinvestment), were already struggling to maximize production before the coronavirus-induced demand hit took place.

Fourth—this one, on the side of mostly non-OPEC+ member-states—includes a cut of 4.5m bpd. But this sum will likely result from bankruptcies, mergers and management decisions that recognize these relatively high-cost wells are uneconomical in this low-price environment. In other words, the market was set to work its magic—in this case, harsh and punishing—regardless of any Easter weekend agreement.

Fifth, another 3m bpd is apparently allocated for purchase by various member-states of the International Energy Agency (IEA) for strategic stockpiles, an enormous volume whose stockpiles were already nearing capacity before the coronavirus crisis hit.

Where to go from here

Overall, the straightforward market fundamentals are punishing and will remain for several months. Even if the inaccurate and inflated figure of 20m bpd in production cuts are uncritically accepted, they alone are still not enough to counter the 25-30m bpd in loss in demand, something that will still take months, if not a few years, to reverse.

In the short- and medium terms, the biggest victims in the upstream will be Canadian drillers and US shale producers, two very different forms of upstream operations that produce very different types of crude but which share the common characteristics of being both high-cost, operated by non-state-owned companies with many carrying heavy debts. The fallout is already hitting their employees—managers, engineers, drivers, to say nothing of related suppliers and service firms—as well as their investors who have struggled to see robust returns-on-investment even before the onset of the coronavirus pandemic. The layoffs, bankruptcies and mergers will unfold in waves, in the oil industries of the United States and Canada as in other countries.