Thursday 28 Mar 2024
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This article first appeared in The Edge Malaysia Weekly on April 20, 2020 - April 26, 2020

WHILE critics see the historic deal between the Organization of the Petroleum Exporting Countries (Opec) and its non-Opec allies to cut production by around 10% of global demand as fragile, it could be the start of a new dynamic in the global oil market.

The Saudi Arabia-led Opec, alongside Russia, is committed to a production cut of 9.7 million barrels per day (bpd), the largest ever by Opec+. The move is expected to be supported by other large producers such as Canada, Brazil, Mexico and Norway amid demand destruction caused by the Covid-19 pandemic. Unlike in the past, the US, while not committing to a production cut, actively participated in the discussion to bring stability to the oil market.

Including the amount that governments have said they will buy for their strategic reserves, estimated at 200 million barrels, industry observers say the entire scheme will see supply fall across the board by 15 million to 20 million bpd.

In hindsight, what started as a shock-and-awe strategy by Saudi Arabia to boost supply and lower prices in order to force large producers to cut output, was disrupted by the Covid-19 outbreak and the ensuing global lockdown that escalated in March, which basically saw a free fall in demand.

As world travel grinds to a halt, businesses shut down and people stay at home, demand has fallen by 25 million to 30 million bpd — rendering any production cut ineffective.

With demand and prices in free fall, producers, including big timers US and Russia, want to avoid a lose-lose situation. It is too early to tell who the clear winner is but beyond this short-term development, there are other key takeaways that would influence future market dynamics.

 

Talks among top three producers

A three-way discussion between the world’s three biggest producers — Saudi Arabia, Russia and the US — would not have happened had the Saudis not flooded the market with crude. As oil prices headed dangerously towards the “huge loss zone” of US$10 a barrel, the three agreed to come to the discussion table, a crucial factor for a successful intervention to stabilise prices.

But as the market has already priced in the current unprecedented shocks, the new deal will put a floor under the US$30 to US$35 per barrel (bbl) band, barring further unforeseen events, says Refinitiv oil research and forecast director Yaw Yan Chong.

That is half of the 2019 average of US$64/bbl, although it is still better than the 18-year lows of US$22/bbl of Brent seen right before the deal.

“I see the US as the real winner of this deal — its oil industry, which has higher costs versus Saudi Arabia and Russia, gets to survive without its committing to any production cut,” Yaw says.

The US, where the shale boom was seen as the anomaly that almost single-handedly contributed to the oversupply in recent years, is not committing its shale producers to cut production.

Still, the depressed market is helping balance the US output — over 170 shale rigs have been left idle since mid-March, owing to the price slump.

The International Energy Agency (IEA) said in a report in early April that about five million bpd (around 5% of global demand) are produced at a loss at US$25/bbl of Brent.

At US$30/bbl, the figure is 3.9 million bpd, of which 2.3 million bpd or 59% is from North America.

In 1Q2020, Brent crude oil price averaged US$49/bbl. The benchmark now hovers around US$30/bbl.

“It is not clear how much the five countries (Norway and the four countries in the Americas) will cut as they have made no commitments to any production cut number. Instead, the refrain is that their production levels will fall owing to natural attrition as a result of falling demand,” Yaw says.

He points at the US, saying production there will fall by up to two million bpd by 2021, compared with its latest three-month average of 13 million bpd, which is currently a record high and the largest in the world. Recall that in 2014, Opec flooded the market when the US upped its production to 9.5 million bpd, from 5.4 million bpd in 2010.

Even with the US’ cutting production to 11 million bpd, that is still a large number. Comparatively, Russia’s production ­averaged 11.24 million bpd over the past 12 months, while Saudi Arabia’s averaged 9.73 million bpd.

“Now, balance this against the demand destruction of 25 million to 30 million bpd by 2Q2020, or a quarter of the world’s demand,” Yaw says, adding that “demand could worsen if the Covid-19 pandemic continues and the current global lockdown is extended”.

This is happening as many nations stretch their lockdowns, some into May, after they saw that the relaxing of the movement restriction order in China resulted in fresh infection clusters. This could very well mean that lifting the movement restriction order will happen later rather than sooner.

 

A test ahead of June Opec+ meeting

Days prior to the Opec+ deal, the US Energy Information Administration (EIA) released data that put global production at an ­average of 99.39 million bpd in 2020, against consumption of 95.52 million bpd.

This would add around four million bpd of excess supply, with EIA expecting inventories to near 85 days of forward demand before paring down to a new range of 75 days — a notch higher than the 60-day range seen last year.

The 9.7 million bpd production cut by Opec+ will take effect for two months ending June 30.  Its impact on pushing up oil price may be limited if the volume of economic activities post-coronavirus is lower  than anticipated.

The official Opec statement added that for the subsequent period of six months, from July 1 to Dec 31, the total adjustment agreed would be 7.7 million bpd, to be followed by a 5.8 million bpd cut for 16 months, from ­Jan 1, 2021, to April 30, 2022.

“The question as to whether there will be more production cuts is dependent on how long the outbreak continues,” Refinitiv’s Yaw says. “Opec+ is scheduled to meet again in June and they have kept open the question of whether further cuts are necessary.

“My take is that [the production cut agreement] will last as long as the market remains in its current poor state. Bear in mind that beyond the Opec+ countries, none of the other producers have actually committed to any formal production cuts and can restore supply as soon as it is economically viable for them to do so.”

 

Politics, policies at play

According to Opec, time and again it has shown its continued relevance in the oil market, as opposed to claims by its critics that the cartel is dead.

“We have demonstrated that Opec+ is up and running and alive,” Saudi Arabian Energy Minister Prince Abdulaziz bin Salman reportedly told Bloomberg after the deal was struck.

Meanwhile, US President Donald Trump told reporters in the White House that while he “hated Opec” and called the organisation “a fix”, the aim is to keep the industry afloat and reduce job cuts — a move pundits say is crucial ahead of the presidential election in November.

At current levels, the view is that no oil-producing country except Saudi Arabia can benefit from the low prices.

The current market dynamics resemble the situation in 2015, when an Opec-triggered supply glut to recapture market share — even without demand shock — prompted a painfully slow U-shaped recovery.

Some analysts point out that it will take a year for a meaningful agreement on a sizeable targeted production cut to be reached.

On top of the Covid-19 recession risk, there is also the problem of the rise in global demand for the US dollar, which has pushed its value higher in the short term even as the Federal Reserve tries to address the liquidity crunch. As history shows, a strong US dollar means low crude oil prices, as they are quoted in greenbacks.

With all these factors taken into account, the top oil-producing countries may need to reach a better deal sooner, for their own sakes and the sake of other producers.

 

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