- An unprecedented plunge in oil demand will turn the industry upside down
- …Baby, one more time
- Oops…I did it again
- Oil crash: why Saudi Arabia has started a global crude price war
- Why is Saudi Arabia launching a price war?
- Why did Russia not agree to cut production?
- What will happen to the US shale industry?
- Will prices keep falling?
- What does it mean for big oil?
An unprecedented plunge in oil demand will turn the industry upside down
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EACH DAY about 100m barrels of oil rise from reservoirs deep below Earth’s surface. A ship called Liza Destiny sits off the coast of Guyana, collecting the black stuff from wells on the seabed nearly 2km below. On Norway’s continental shelf the Johan Sverdrup project is ramping up faster than expected.
In Texas some 174,000 wells are at work, from big shale operations to solitary pumpjacks nodding as cattle graze nearby. Last month Saudi Arabia said it would ship a staggering 12.3m barrels a day to customers in April. From the Niger delta to Siberia, oil continues to flow.
The rest of the world, meanwhile, is standing still.
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In recent years oil producers have faced a spectre of depressed demand that could up-end the industry. All of a sudden the wraith has materialised—not concern for the climate, as oilmen feared, but because of covid-19.
Crude fuels the movement of people and goods around the world. A lot of this has stopped as governments limit travel and other economic activity to contain the pandemic. Oil demand has dipped in only two years of the past 35.
In the first six months of 2020 it may plunge by more than 20%.
If that weren’t enough, a brawl between Saudi Arabia and Russia has led to a price war. The price of Brent crude, the global benchmark, fell by more than half in March, below $23 a barrel.
The last time it was this cheap, in 1999, Britney Spears topped the charts and the dotcom bubble had not burst.
As for the drop, “nothing this has ever happened before,” says Daniel Yergin, a historian and vice-chairman of IHS Markit, a consultancy.
…Baby, one more time
Saudi Arabia and Russia were expected to discuss production cuts with other petrostates on April 9th, after The Economist went to press, then again at a G20 meeting the next day. Any deal is unly to end oversupply. Covid-19 is already exposing vulnerabilities of petrostates and oil firms. With prices poised to sink lower, the entire industry may be forever transformed.
A few months ago demand was expected to rise modestly this year. But trouble festered. Surging production in Guyana, Norway and Brazil seemed sure to weigh on prices. More worrisome, the world’s energy powers were increasingly at odds.
In 2016 Russia teamed up with the Organisation of the Petroleum Exporting Countries (OPEC), led by Saudi Arabia, in an attempt to offset booming American shale production. This OPEC+ alliance proved both fractious and ineffectual. Russia regularly ignored the group’s self-imposed production limits, forcing Saudi Arabia to curb its own output more sharply.
That pushed oil prices high enough to shore up investment in American shale but too low to balance the budgets of Saudi Arabia and other petrostates.
America, which in 2018 eclipsed Saudi Arabia and Russia as the world’s top oil producer (see chart 1), indeed looks the main beneficiary of OPEC+. In an effort to snuff out shale Russia shocked OPEC in March by refusing further production cuts. Furious Saudis declared the price war in response.
American frackers and international oil giants had problems of their own. Even as shale production surged, shale firms’ valuations sank, with more investors sceptical of their ability to produce steady profits.
Worries over climate change clouded the long-term prospects of supermajors such as ExxonMobil and Royal Dutch Shell while other industries offered better short-term returns.
Energy was the worst-performing sector in the S&P 500 index in four of the past six years.
The oil market has witnessed big shocks before (see chart 2). In the late 1990s supply rose while a demand-sapping financial crisis rocked Asia. In 2014 the Saudis opened the taps in an attempt to drown American shale. But never before has anyone seen anything covid-19.
In the coming weeks crude will come perilously close to filling the capacity to store it. Citigroup, a bank, says that global supply needs to fall by 10m barrels a day, 12% of the total, for tanks not to spill over.
Prices in parts of the world may fall below $10, says Goldman Sachs, another bank—or turn negative, as producers pay to have their oil taken away rather than shut in wells.
With OPEC+ in tatters and America’s shalemen clamouring for help, on April 2nd Donald Trump, who two days earlier welcomed cheap oil as a tax cut for American consumers, tweeted that a production deal between Russia and Saudi Arabia was imminent. This pushed Brent up by 20%, the biggest one-day gain since 1986.
Mr Trump wanted to support American oil companies further by buying their crude and storing it in the government’s strategic reserves. But he is not an autocrat presiding over a petrostate and his idea was rejected by Congress.
Another of his suggestions, to levy a tariff on imported oil, might benefit some of America’s 9,000 or so oil and gas producers. But it would harm integrated giants such as ExxonMobil, which use heavier overseas crudes in their American refineries.
Large companies also resist national production caps that would prop up smaller, less profitable rivals.
Some petrostates have trouble grasping that Mr Trump cannot call oil bosses and tell them to do this or that, says Mr Yergin. But, he adds, the president does have “an enormous amount of influence”.
If the government’s power over oil firms is limited, its control of aid is plainer.
A group of American senators from oil-producing states have threatened to withhold military support for Saudi Arabia if it refuses to limit output.
Mr Trump may therefore help broker an agreement, particularly if armed with data showing that American companies are already cutting spending. However, continued animosity between Russia and Saudi Arabia, combined with instability within OPEC’s smaller members, will lead at best to temporary production deals of limited impact.
Output cuts agreed now would take time to be felt in the physical market. Even a cut of 15m barrels a day—around ten times what the Saudis sought in March—would be dwarfed by covid-19’s obliteration of demand, of as much as 20m barrels a day in April.
“We are not going to fully recover until we are through corona,” says Mike Sommers of the American Petroleum Institute, a powerful lobby group.
Even then, it is unclear that the industry, in its current form, recovers at all. Russia is in a position of relative strength. It can balance its budget with oil at $42 a barrel and has more than $500bn in foreign reserves. Saudi Arabia has low operating costs of just $3.
20 a barrel, about one-third of America’s, according to Rystad Energy, a consultancy.
That would help it in a drawn-out battle for market share, though the current crisis has hit about a decade too soon for comfort—economic reforms to diversify the Saudi economy away from oil are a work in progress and the country still needs $84 a barrel to finance its budget.
Other producers look more vulnerable. Low oil prices will tighten the vise on Iran and Venezuela, each already squeezed by American sanctions. In Iran deteriorating finances will make it even harder to deal with high rates of coronavirus transmission.
Cheap oil will exacerbate strife in Libya and may feed unrest in Iraq, as well as Algeria. A few big projects in Africa require an oil price of $45 or more just to break even, reckons Rystad; many may now be put on hold. Listed oil giants are paring spending in an effort to protect dividends.
ConocoPhillips has delayed drilling in Alaska. Chevron has cut its capital budget for this year by 20%.
More damage will come as low prices compel firms and governments not just to cancel new projects but mothball existing wells. That may hurt countries with high production costs, Brazil and Britain.
The sudden plunge in demand means that shut-ins will depend as much on logistics as on production cost, argues Damien Courvalin of Goldman Sachs.
As inland tanks fill, landlocked wells with limited access to storage and transport will suffer.
Canadian crude has the double misfortune of being costly and hard to ship—on April 7th a barrel of Western Canadian Select fetched about $10, a third as much as Brent. Some inland American and Russian production may stop, too.
Oops…I did it again
When the world economy begins to open up after the pandemic, it will find the oil industry looking different. In America less productive shale beds may be gone, finally “flushing out production that was never really warranted”, says Ed Morse of Citigroup.
The number of shale bankruptcies jumped by 50% last year. In 2020 more inefficient companies will vanish. Some wells, once closed, are too costly to reopen.
And with oil at $35 a barrel, the return on renewable projects—which most energy firms have largely ignored—can rival that of a new oilfield, notes Valentina Kretzschmar of Wood Mackenzie, a consultancy.
A sudden loss of production could, if demand picks up quickly, create an opportunity for more drilling. But investors may now be warier of oil companies’ spending plans.
Especially if they suspect covid-19 fundamentally alters oil demand: more people may work remotely, a lot of international travel could come to be seen as unnecessary and companies may bring supply chains closer to home to avert disruptions.
“Are we about to see a structural change in oil consumption?” wonders Mr Courvalin. “It is a very valid question.” Oilmen used to take comfort that it was an abstract one. No longer. ■
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This article appeared in the Briefing section of the print edition under the headline “Upside down”
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Oil crash: why Saudi Arabia has started a global crude price war
Oil prices crashed by as much as 30 per cent after Saudi Arabia fired the first shots in a price war, in crude’s biggest one-day fall since the early 1990s Gulf war.
Riyadh’s threat to discount its crude and raise production prompted the price of Brent crude, the international oil marker, to fall to as low as $31.02 a barrel. West Texas Intermediate, the US benchmark, fell to $27.71 a barrel.
But why did the world’s top exporter decide to move so aggressively, with demand reeling from the coronavirus crisis? And what does it mean for the wider oil industry?
Why is Saudi Arabia launching a price war?
Saudi Arabia had wanted to lead Opec and Russia in making deeper cuts to oil production to support crude prices in the face of the coronavirus outbreak, which has disrupted global economic activity. But when Russia baulked at the plan, the Gulf kingdom turned on an ally it had worked with to prop up the oil market since 2016.
Riyadh responded by raising production and offering its crude at steep discounts. Analysts said that was an attempt to punish Russia for abandoning the so-called Opec+ alliance.
Saudi Arabia may also have wished to cement its position as the world’s top oil exporter, analysts added. The move demonstrated that Riyadh was willing to openly take on Russia and other higher cost producers.
“There was a consensus among Opec [to cut production]. Russia objected and has said that from April 1 everyone can produce whatever they . So the kingdom too is exercising its right,” said one person familiar with Saudi oil policy.
Analysts have questioned the wisdom of Saudi Arabia’s approach. Its economy is not immune to a price crash, even if it believes it can win market share from its rivals.
But under Mohammed bin Salman, crown prince, the kingdom has gained a reputation for risky and unpredictable moves when it has felt the need to assert itself.
Why did Russia not agree to cut production?
Russia said it wanted to see the full impact of the coronavirus on oil demand before taking action.
But Moscow has also been keen to test the US shale industry. It believes that cutting output would only hand a lifeline to a sector whose growth has turned the US into the world’s largest oil producer, gaining customers at Russia’s expense.
US sanctions on Russian energy companies, including those that targeted the trading arm of state-backed oil champion Rosneft last month, and attempts to halt the Nord Stream 2 gas pipeline to Germany, have infuriated the Kremlin.
US shale has struggled to be profitable despite its growth over the past decade. People briefed on Moscow’s strategy said Russia thought there was an opportunity to hurt the US oil industry.
“The total volume of oil that was reduced as a result of the repeated extension of the Opec+ agreement was completely and quickly replaced in the world market with American shale oil,” a spokesman for Rosneft said on Sunday.
Saudi Arabia’s approach to a possible deal with Russia was a take-it-or-leave-it demand to join them in reducing an additional 1.5m barrels a day, taking total cuts to 3.6m b/d or roughly 4 per cent of global supply. That is thought to have riled Moscow, which does not see itself as a junior partner.
What will happen to the US shale industry?
The price crash came at a difficult time for US shale. While production has soared over the past decade, leapfrogging that of Russia and Saudi Arabia, the industry has burnt through borrowed cash, alienating investors.
That has left it vulnerable to a drop in prices. The huge oil price fall since the start of the year has thrown any remaining expansion plans into doubt.
The hit to production, however, may be muted. Many of the small independent producers that make up most of the US shale sector have hedged their output at higher prices. Supply is unly to fall immediately.
“In our view, US shale production will not decrease fast enough to vindicate the Russian views on curbing it,” said Ayham Kamel, head of Eurasia Group’s Middle East and North Africa practice.
But many shale producers could struggle to secure new financing to roll over their existing debts. Many junk bonds — those rated as below investment grade — issued by energy companies are traded in distressed territory.
For President Donald Trump the price crash had posed a conundrum. Lower oil prices are an important part of his pitch to voters, frequently calling on Opec to bring them down. But a prolonged price fall could spell economic trouble for energy-producing states such as Texas and North Dakota.
Will prices keep falling?
Hopes for an oil price recovery in the short-term have been pinned on the coronavirus outbreak being contained faster than expected.
Traders have warned that global oil demand in 2020 could contract for the first time since the financial crisis more than a decade ago. Oil consumption could be at least 1-2 per cent lower this year than what analysts had expected at the beginning of the year, with demand taking a hit from restrictions on air and road travel.
But with the possibility of the coronavirus developing into a global pandemic, crude’s short-term prospects look bleak.
This new Saudi approach will only harden Russia’s position
Amrita Sen, chief oil analyst at Energy Aspects
Much depends on how aggressively Saudi Arabia will raise production. It has more spare capacity than any other country, so it can boost output quickly and potentially add more than 1m b/d in the coming months. It can also pull oil storage to increase exports.
Russia’s ability to boost its output is probably more constrained. Lower prices could jeopardise President Vladimir Putin’s longer-term promises to invest in areas such as infrastructure and social spending.
Saudi Arabia may have hoped that the enormity of the price fall would force Russia to return to the negotiating table, but that seems unly.
“This new Saudi approach will only harden Russia’s position,” said Amrita Sen, chief oil analyst at Energy Aspects.
If very low prices persist, other oil producers will eventually be forced to scale back expansion plans or their output could drop owing to a lack of investment. But that could take a long time and oil demand growth was already forecast to slow in the second half of the decade. Betting on a quick price recovery looks premature.
What does it mean for big oil?
After oil prices crashed in 2014 the s of Royal Dutch Shell, BP and ExxonMobil retrenched.
They cut costs aggressively, sold off assets and streamlined their operations to stay profitable at lower oil prices and protect their business from market slides.
But while they have become more efficient, generating more cash when prices averaged around $65 a barrel over the past two years than when they traded at $100, they face different pressures.
Companies have been desperate to maintain dividends and payouts to shareholders unsettled by predictions oil demand could peak in the next decade. At the same time they need to reduce debt and look to new energy sources such as renewables, fearing a long-term shift away from fossil fuels.
With oil at less than $40 a barrel, many investors doubt this is possible. Share prices will probably come under pressure in the coming days.
“Highly leveraged companies will be most impacted by the decline in crude prices,” said Bernstein analyst Neil Beveridge.