COVID-19 and the oil price collapse
You’ve probably seen the headlines: On March 9, oil prices experienced one of the most significant price drops since 1991.
Why did this happen? The severe collapse is a direct result of failed negotiations between OPEC (Organization of the Petroleum Exporting Countries) and Russia.
With COVID-19 causing an economic slowdown, OPEC recommended an oil production cut to accommodate reduced demand.
Russia seemingly perceived that a cut by OPEC and Russia would favor US shale producers, whose production growth has shifted oil flows and weakened the relative position of both OPEC and Russia1.
Failing to reach an agreement, Saudi Arabia announced that it would seek to gain market share by offering discounts to customers in Northern Europe, the Americas and Asia.
Additionally, the country announced that it intends to add 2 million barrels per day to its production over the coming months.
The United Arab Emirates followed Saudi Arabia’s lead and promised to raise output in the near future as well.
This announcement contributed to the drop in oil prices, which are now at levels not seen since 2015. While not as severe as the price collapses of 2008 or 2014, the underlying driver—to take out production capacity—is no less troubling.
The impact of this move is already being felt as the rig count has dropped, companies have curtailed discretionary spending, capital budgets have been cut and earnings forecasts reduced. Oil and gas stocks across the value chain have been rocked.
This is putting some companies at risk of not being able to refinance debt or meet existing debt covenants.
How long will this last?
Prices for Brent crude have dropped into the $35 per barrel range. Given we have not seen prices in this range for several years, few companies have scenario-planned for $30 oil.
How long will the downturn last, and how far out should companies plan for this lower-price environment? That depends. While prior downturns have varied in length, this situation seems ly to be of a shorter duration. If Russia and OPEC reconcile and arrive at a mutually acceptable production cut, we could potentially see a near-term recovery.
However, betting on personalities and relationships is an unpredictable exercise. A more ly scenario is a prolonged recovery as the market strives to rebalance after Saudi Arabia adds 2 million barrels per day and demand recovers from the COVID-19 impacts. Given normal production decline curves, it could take up to a couple of years to rebalance the market under this scenario.
What is the impact on the industry?
As with previous downturns, the industry has moved to cut discretionary and capital spending. Going forward, a key question for all oil and gas companies should be: Do you have the financial reserves to weather the storm or even capitalize on the tumult in the industry?
Operators will also ly reduce their capacity and cost structure through staff reductions and related measures as their activity levels decline. However, each company first will want to assess its positions by reviewing its balance sheet and liquidity to reset the company’s baseline. From there, it can develop its options as it faces a new price environment.
Next, companies should assess how profitability and cash flow generation can support ongoing operations. At current price levels, how much cash will their assets generate? To quantify asset profitability, they’ll need an understanding of their cash operating expenses, taxes and other cash expense items.
The analysis should be at the field or well level, as cash forecasts will be dependent on this “cash margin” against the decline curve.
Finally, companies will want to carry out a review of capital and corporate cost budgets to identify not only marginal investments, but also those discretionary items that can be culled.
Once a new baseline is established, companies can develop scenarios and strategies. While the initial urge is to react with austerity, taking a more measured approach will ly yield a better result. Austerity measures should be tempered to preserve long-term objectives. While moving quickly may create an advantage, knowing where you’re going makes your moves more impactful.
Lessons learned from prior downturns
What else should companies do to respond to this crisis? Here are some strategies lessons from prior downturns:
- Understand your position. Determine the health of your balance sheet and cash flow. Know how to generate free cash and profits in a low-price environment and find your break-even point.
- Be surgical with cuts, while balancing short- and long-term needs. Plan for the future after prices begin to recover. What assets, people and capabilities will you need or want then? Look for ways to preserve what you will need later.
- Look for opportunities with an innovative eye. Whether dealing with suppliers, customers or partners, seek alternatives that allow you to preserve relationships, co-create solutions and sustain both businesses. Look for M&A opportunities, as distressed assets or non-core assets are a potential source of cash for embattled companies. These opportunities often lead to lower cost structures, expanded business and sustained relationships.
- Search for areas to outsource. If you’ve looked into outsourcing portions of your corporate functions, moving your IT to the cloud, or moving internal non-core operating functions to contractors, now is the time to revisit those options. These changes can help lower your operating costs and reduce maintenance capital.
- Be ready to ramp back up. Look for signs of a turnaround. Has production dropped to meet demand? Are Russia and OPEC moving closer to a deal? Again, being a first mover will help create opportunities, allow you to capitalize on the oil price recovery, and lock in lower rates from suppliers as you become one of the first to increase spending.
These steps can help oil and gas companies avoid many of the pitfalls of prior downturns. The oil and gas industry is cyclical and volatile and will remain so. Successful companies have weathered many of these downcycles and have often emerged stronger. While these downcycles are painful, measured, informed decision-making can help position your company to capitalize on the market recovery.
Oil price rise risks OPEC+ cheaters returning to old ways | DW | 11.02.2021
Oil prices are having a dream run as traders bet on vaccine rollouts, boosting fuel demand as economies reopen.
Benchmark crude contract Brent North Sea is trading at a year high of $61 (€53.1) a barrel, having soared over 60% since the emergence of successful coronavirus vaccines in November. West Texas Intermediate (WTI) futures, the US benchmark, has risen to $58 a barrel.
The increase in oil prices, however, could give Saudi Arabia, the de facto leader of the Organization of the Petroleum Exporting Countries (OPEC), a new headache; some of its fellow oil producers, which have been complying with pledged output cuts in keeping with a deal to stabilize oil markets, might now be tempted to go rogue.
“OPEC+ producers are anxious to ramp up production and higher oil prices will ultimately lead to massive cheating on production commitments,” Edward Moya, senior market analyst at OANDA trading group, told DW. “For OPEC+ members, it is all about market share and if demand improves along with prices, we will see compliance go out the window.”
Poor compliance has beset OPEC+ — an alliance between the oil cartel members and a handful of Russia-led producers — since its inception in 2016. Several alliance members, including Russia, Iraq and Nigeria, have been notorious for producing more than their pledged quotas, much to the annoyance of Riyadh, which has been left to do much of the heavy lifting.
But when last year's COVID-19 travel restrictions and sweeping lockdowns battered oil demand and caused oil prices to crash, even trading below $0 a barrel in the US in April amid a severe shortage of storage space, oil producers didn't have much incentive to overproduce.
Saudi Arabia-Russia tension
OPEC+ has claimed that there was close to full compliance with oil production cuts between May and December under the terms of its current deal, with even the so-called laggards receiving an impressive report card. Saudi Arabia has been strict in ensuring compliance, even calling on those breaching targets to compensate in the following months.
The alliance agreed to the biggest coordinated cuts on record — 9.7 million barrels of oil per day (bpd), or 10% of total global supply — in April last year when the COVID-19 pandemic brought the global economy to a screeching halt. That figure has gradually decreased to 7.2 million bpd amid recovering fuel demand.
In December the grouping committed to gradually bring back no more than 500,000 bpd on a monthly basis. The increase in production was put on hold for February and March as many countries imposed new coronavirus lockdowns. Saudi Arabia volunteered to cut its production by an extra 1 million bpd in the two months as part of the deal.
With oil prices breaching the $60 a barrel mark and crude stockpiles falling, Russia and some other OPEC+ members are calling for a faster ramping up of production than was agreed in December, reigniting tensions with Saudi Arabia. The group will meet on March 4 to discuss the production target for April.
“I do think that this meeting is going to be more difficult for Riyadh to argue for restraint, even though from a balanced perspective they [OPEC+] should restrain.
So, make no mistake about that,” Eugene Lindell from Vienna-based JBC Energy told DW. “The demand has not come back. So, the price is in a way artificially high. It's gotten ahead of itself.
It's pricing more on future expectations than on current fundamentals.”
Russia's shale worries
Russia, among the world's top three oil producers, has been calling on OPEC+ to ramp up production under pressure from its own producers, which are looking to cash in on the price rise.
Moscow, whose budget is more resilient to low oil prices than most major oil producers, is also worried that the recent increase in oil prices could lead to US shale players making a comeback after taking a battering during the pandemic, leading to further erosion in its market share.
Rystad Energy estimates that if WTI stays in the $50-55 per barrel range, then at least 300,000 bpd in oil production will be added by US shale companies by year-end 2021.
Moscow has already been receiving favorable conditions within OPEC+. It was allowed to produce an extra 65,000 bpd in February and March even as others, barring Kazakhstan, were told to hold output steady. Its undercompliance with pledged output cuts have also largely been ignored by Riyadh.
“As the oil price ticks up, they [Moscow and Riyadh] actually each have less leverage on one another.
In a high market oil price environment, the two countries become less dependent on one another for market regulation,” Rystad Energy oil markets analyst Louise Dickson told DW.
“In a $60 per barrel world, Saudi's threat of releasing more than 1+ million bpd of spare capacity onto the market becomes less of a threat. At the same time, as prices tick higher, Russia's participation in the deal also becomes less crucial.”
Saudi Arabia's predicament
Saudi Arabia, which has been forced to dive into its cash reserves to meet its budgetary needs, would oil prices to rise even further to help fund Crown Prince Mohammed bin Salman's ambitious spending plans as he looks to reduce the country's heavy reliance on oil.
“As long as this multi-billion project remains a top priority for the Kingdom, it may not have any better option than holding back oil production to fund it. Even if it has to go at it alone, as was the case with the 1 million bpd cut in February and March 2021,” Dickson said.
Even if Riyadh manages to pacify calls for a faster raising of production targets, it knows all too well that there are bigger challenges waiting in the wings, not least the potential return of Iranian oil as the Biden Administration in Washington looks to bring back Tehran to the negotiating table to revive the Iran nuclear deal.
“It is amazing the production cut agreement has lasted this long. 2021 could see the return of Iranian and Venezuelan oil and that will complicate how everyone gets their fair share,” Moya said. “Russia, Iraq, and Nigeria will ly be the ones everyone expects to break away from the agreement.”