What is Happening to the Price of Oil?
How will the price of oil play out in the coming months?
B efore the first cases of COVID-19 were reported out of China in December last year, West Texas Intermediate (WTI) crude was trading at around $60/barrel and Brent crude at $66/barrel. Today, WTI crude is trading at around $20/barrel (having dipped briefly on March 30 below $20/barrel), Brent crude at about $26/barrel.
We know that the price of oil is determined by supply and demand, and that the COVID-19 pandemic has resulted in an unprecedented drop in demand; plus a price war between Russia and Saudi Arabia is pushing prices down further by increasing supply, but why is the latter happening and what are the chances of a let up?
The Demand Side of the Equation
This pandemic has forced governments to shut down whole economies. Consumer and corporate demand for goods and services including travel and transport have plummeted while factories (such as car plants¹) have stopped production. When India locked down its 1.3 billion people on March 24², it resulted in an estimated 2.8 billion people in lockdown globally. That’s about 1/3 of the global population not driving or taking public transport, buying goods, building infrastructure, or working in factories.³
The drop in energy use is so deep, analysts are forecasting that oil demand could fall by as much as 20 million barrels a day for April.⁴ To put that in context, the U.S. Energy Information Administration forecasted global liquid fuels consumption in Q2 2020 to be just over 100 million barrels per day (and growing) in October 2019⁵. The speed and depth of the fall in demand is unprecedented.
As China locked down large swathes of the country towards the end of January (and before other countries did), the world started to worry about the drop in Chinese factory activity, and its impact on global supply chains. The effect on the demand for oil would depend on the length of the lock down, and how quickly production could get started again. Since China is the world’s largest importer of oil, consuming about 14 million barrels a day pre-lock down, any reduction in demand would have a meaningful impact on oil price.
On February 2, Bloomberg reported that Chinese demand for oil had fallen by about 3 million barrels a day, or 20% of consumption. This was thought to be “the largest demand shock the oil market suffered since the global financial crisis of 2008–2009, and the most since the Sept. 11 attacks”⁶. WTI crude fell to around $50/barrel and Brent crude fell to around $56/barrel.
As city after city around the world, then whole countries enforced lock-downs to prevent the spread of COVID-19 overwhelming healthcare systems, demand for oil has fallen even more precipitously. However, the dynamics of the fall of oil prices at this point is muddied by the supply side, driven by geopolitics.
The Supply Side of the Equation
On the 2nd of January 2020 as the world was trying to digest the Hubei lock down, news broke that the US had killed one of Iran’s top generals, Major General Soleimani⁷. The prospect of Iranian retaliation on US allies⁸, or indeed a war⁹ (therefore affecting oil supply) caused only a brief and muted rise in the price of oil. WTI crude peaked at $63.27 while Brent crude at $68.91 on the 6th of January, a rise of approximately 4%.
The Iranian missile strike retaliation on January 7 indicated that Iran was not going to escalate the conflict and the price of oil immediately started its decline. What was notable was that tensions in the Middle East no longer cause sharp shocks in oil prices. In a New York Times article following this event, a banker in the sector was quoted as saying that “oil has become a broken barometer for gauging Middle East tensions”.¹⁰
Perhaps one reason this is the case is that the US is now the largest crude oil producer in the world. In 2018, crude oil production in the US was thought to have surpassed both Saudi Arabia and Russia, the two largest producers of the last decade.¹¹ Hence production buffers from Russia and the US would ensure some alleviation to a supply disruption in the Middle East. What this also means is that the OPEC cartel has to work harder to control the global price of oil. Contrast this with the 1973 Arab oil embargo¹², which resulted in a shortage of oil and the ensuing recession. The subtext here is that power has shifted from the Middle East.
OPEC Tries to Kill US Shale
After their November 2014 meeting, OPEC tried to kill off US shale production by flooding the market with an additional 4 million barrels a day, hoping to drive prices below the breakeven for US shale producers. However, OPEC soon realised that, not only did the strategy not work, it created a glut in the market which depressed oil prices, hurting their own economies: Brent crude dipped to $26/barrel on January 20, 2016.¹³
In November 2016, OPEC, plus non-OPEC countries such as Russia and Venezuela, which represented half of the world’s oil production capacity, agreed to a tightly monitored reduction of supply by around 1.75 million barrels/day for six months.¹⁴ This agreement would be extended every six months since, which has resulted in a steady rise in the price of oil. Brent crude passed $60/barrel a year later and peaked at around $80/barrel a year after that in 2018.
OPEC heralded a new era of cooperation and even re-branded the new collaboration as “OPEC-Plus”. But all was not well with the relationship between Russia and Saudi Arabia.
Something is Rotten in the State of Denmark
As China became the world’s largest importer of crude oil in 2017¹⁵, and even as Russia and Saudi Arabia cut production in accordance to the OPEC-Plus agreement above, they were jostling fiercely to supply to Chinese refiners.
Russia beat Saudi Arabia in 2016, 2017¹⁶ and 2018¹⁷ as the top supplier while Saudi Arabia boosted its export to China by 43% in 2019 and stole back the crown that year¹⁸.
In May 2019, Saudi Aramco, the country’s oil producer, went on record saying that it aimed to boost oil supply to Europe by 300,000 barrels a day, despite the agreed production cuts, and proceeded to open an office in London that summer. Its traders started to aggressively execute swap contracts with European oil refiners.¹⁹ A reported Russian oil contamination by European refiners in April 2019 also likely hurt Russia’s oil business in the region.²⁰
In August 2019, Aramco cut oil prices to Asia to boost its market share.²¹ However, when it’s facilities were damaged in a drone attack in September wiping out 5% of its capacity, Russia jumped on the opportunity to negotiate an increase in supply of crude to India’s refineries.²²
It is against this backdrop of competition that we have to view the March 2020 moves by Saudi Arabia and Russia.
However, before that discussion, we should consider the long term strategy of Saudi Arabia.
The Coming Peak Oil Demand
As the world becomes more conscious about using hydrocarbons as its main energy source, and while technologies to tap alternative “green” energy sources improve, and the automobile industry starts moving away from the internal combustion engine, Saudi Arabia has been planning for the eventual decline of the demand for its oil.
How environmental rules affect the demand and price of oil is not theoretical. As 2019 drew to a close, the prices of high-sulphur (“sour”) fuel oil fell. The December futures for sour crude was trading at a $30 discount to the “sweeter” Brent crude.²³ This is because high sulphur fuel is used by ships, and the International Maritime Organisation’s rules for reduced emissions kicked in at the start of January 2020.²⁴ Crude produced by both Russia and Saudi Arabia are of the “sour” variety.
In 2016, Saudi Arabia published a National Transformation Programme 2020 called Vision 2020²⁵ which initiated, publicly, the attempted diversification of its economy. In the meantime, there has been discussion of a “fast monetization” strategy.²⁶ In this scenario, if the assumption that the oil in the ground is going to be worth a lot less in future, especially after “peak oil demand” due to the factors discussed above, then it may make sense to increase production and sell as much oil as possible now.
In a way, Aramco’s IPO can be seen as a step in that direction. On listing, the company essentially promised its future oil production in exchange for investors’ cash today. This cash influx can now be used to develop the infrastructure to increase production. And since demand is unlikely to increase in step with any planned aggressive increase in production, Saudi Arabia has to grab market share from its competitors today.
The Price War
In November 2019 when OPEC-Plus met to extend their 6-month production cut agreement of 2016, the meeting was already splenetic.²⁷ Russia eventually agreed to an OPEC-Plus 500,000 barrel/day cut in addition to the cuts already agreed in 2016, but only up to the end of the first quarter of 2020.²⁸ The price of oil started to climb from $60/barrel (Brent crude) to $70/barrel at the end of the first week of January.
Against this backdrop, we find that demand had fallen sharply for crude oil when China shut down the Hubei Province in January. This in turn had led to a fall in the price of crude. By the end of February, Brent crude was trading at just under $50/barrel and WTI crude at just under $45/barrel.
OPEC-Plus then held an “extraordinary” meeting on Thursday March 5 to discuss deeper cuts in production. But by the next day, Russia dramatically ended its 2016 agreement with OPEC²⁹ and the price of oil plunged 10%. WTI crude fell from $45.90 to $41.28/barrel. Similarly Brent crude fell $49.99 to $45.27 by the time the weekend arrived.
But the worst was yet to come.
The Gloves Come Off
Saudi Aramco sets its oil prices on the same day of each month, without fail. However, on March 5, the day of the “extraordinary meeting”, and a day after the Saudi head of the Ministry of Energy, Prince Abdulaziz, had met the Russian Energy Minister Alexander Novak, it failed to do so, without explanation.
On Saturday March 7, Saudi Arabia stunned the world when Aramco set discounts for its April oil by $4–6/barrel for Asia and $7/barrel for the US just before midnight Saudi time.³⁰
Saudi Arab Light crude is a direct competitor to Russian Urals crude, as both have not too dissimilar characteristics and can be feed-stock for the same refineries.³¹ For European refineries, Aramco published an $8/barrel discount for Arab Light crude, resulting in a price $10.25/barrel below Brent crude, while Russian Urals crude was trading at a $2/barrel discount to Brent crude.³²
On Sunday the country had also told some market participants that after the OPEC-Plus agreement with Russia expired at the end of March, it was capable of pumping over 12 million barrels a day.
By the end of the first day of the new week, Monday March 9, Brent had fallen to $34.36/barrel and WTI crude to $31.13/barrel. A precipitous fall of approximately 25% in price to a four year low.
On Tuesday March 10, Saudi Arabia confirmed that when the 2016 OPEC-Plus deal expired with Russia at the end of March, it would increase production by over 25% from 9.7 million barrels/day to 12.3 million barrels/day.³³ Simultaneously it began a search for supertankers to carry the extra oil production to come.³⁴ At this point in time, remember, Italy had already locked down 11 municipalities in Lombardy and in fact would announce a nation-wide lock down on the same day.³⁵ South Korea had enacted emergency measures to contain the virus outbreak, Japan had closed all schools for a month, and there was already a global shortage of masks.
Extending an olive branch, on that same day, Novak and later the Kremlin said that Russia had not ruled out further talks with OPEC (while simultaneously saying that it can increase output by 500,000 barrels/day).³⁶ This, and a 430.8 billion yen ($4.1bn) stimulus package announced by Japan³⁷, plus word that the White House was “strongly considering” federal aid for US shale companies³⁸, caused WTI crude to climb 10% to $34.36/barrel and Brent crude by 8% to $37.22/barrel.
The relief, however, was short-lived. On that same day, Prince Abdulaziz told Reuters that he did not see a need to hold a further OPEC-Plus meeting.³⁹ And a technical meeting between OPEC-Plus members scheduled for March 18 was called off a couple of days later on Thursday, March 12, signalling to Russia that Saudi Arabia was pulling up the drawbridge.⁴⁰
By March 18, Brent crude hit a low of $26.69/barrel, and had since, apart from one day, remained below $30/barrel. Similarly WTI crude hit $20.42/barrel but it dipped further to $19.48/barrel on March 30.
The Collateral Damage Side of the Equation
The cost of extracting and producing oil varies greatly. Thanks to Aramco’s IPO prospectus and the 2019 Medium Term Note (debt) prospectus, we know that it costs Saudi Arabia an average of 10.6 SAR (about $2.80) to extract a barrel of oil.⁴¹
In the same IPO prospectus it revealed that Aramco’s after tax break-even cost is $10/barrel, while Russia’s is reported to be at 2,508 roubles per barrel (about $32)⁴². Russia, however, has claimed that it can live with $25/barrel oil for 6–10 years.⁴³ This is because over the years it has built up a substantial reserve of petrodollars.
US shale, on the other hand, is thought to cost its producers in the high $40/barrel to breakeven on average (between $20–80/barrel depending on the site).⁴³ As the price of oil remains depressed in the $20/barrel range, the higher cost producers will have to consider shutting-in wells. However, well shut-ins are not as simple as turning a valve off. The process can damage wells and incur capex to reinstate at a later date, if at all possible.
What is certain is that the current price of oil cannot sustain US shale production, and eventually could lead to a reduction in US oil production capacity as companies go bust and wells stop pumping. If this were to happen, market share will flow back to OPEC and Russia, changing the balance of power.
Where will oil price go from here?
As I write this, it does not seem that either Russia or Saudi Arabia will back off with Brent crude at around $25/barrel and WTI crude at just over $20/barrel.
Because of the reduced demand for oil, refiners will have reduced their refining output. Indeed the International Energy Agency revised down their estimates of global refining intake in the first quarter of 2020 by 1.2 million barrels/day, about 10%.⁴⁴ This was mainly due to China, but as the rest of the world stops moving, this trend will carry on into Q2 and deepen, given the global scale of lock downs.
Parallel to this fall in energy demand is a ramping up of production starting April as Saudi Arabia attempts to gain market share, while enacting some form of fast monetization, and slowly reducing the capacity and hence geopolitical leverage of US shale.
Russian motivation is less clear, although there are elements of market competition with Saudi Arabia and trying to defeat Aramco’s increasingly aggressive business tactics while flexing its geopolitical muscles. Certainly the Kremlin won’t shed a tear, either, if the US shale industry were to be irrepairably damaged.
This is already leading inventories to rise and storage capacity to fall.⁴⁵ One analyst has recently predicted that the world’s oil storage will be at full capacity in a few months.⁴⁶
In addition, speculators will be buying and storing oil to be sold for a profit later. If there is a big enough perceived difference between the current price of oil and the price at which it can be sold in the future, even more costly floating storage (rented tankers) will be used.
As more and more oil saturates the system, and if demand does not pick up, for even though China is recovering, the rest of the world has yet to, the price of oil will likely fall even further.
At some point, even if OPEC and Russia calls a halt to the price war, there will be so much surplus inventory that it would take many months to clear and for the price of oil to reach pre-COVID-19 levels. We could, therefore be in a low oil price environment out to Q4.
Perhaps the one silver lining in all of this is that the low price of oil will exert a downward pressure on inflation and help countries speed up their recovery once they emerge from lockdown.
Sites and articles cited
¹ Coronavirus: BMW, Honda and Toyota suspend UK car production. BBC News, March 18, 2020. https://www.bbc.co.uk/news/business-51944301
² Coronoavirus: India puts 1.3 billion people under ‘total lockdown’. The Journal (Ireland). March 24, 2020. https://www.thejournal.ie/india-lockdown-coronavirus-5056171-Mar2020/
³ One third of humanity under virus lockdown. AFP (via MSN). March 25, 2020 https://www.msn.com/en-us/news/world/one-third-of-humanity-under-virus-lockdown/ar-BB11Fk7V
⁴ Oil Demand Is Down as Much as 20 Million Barrels a Day, Vitol Says. Bloomberg. March 25, 2020. https://www.bloomberg.com/news/videos/2020-03-25/vitol-says-oil-demand-is-down-as-much-as-20-million-barrels-a-day-video
⁵ See Figure 1. in This Week in Petroleum. U.S. Energy Information Administration. October 9, 2019. https://www.eia.gov/petroleum/weekly/archive/2019/191009/includes/analysis_print.php
⁶ China Oil Demand Has Plunged 20% Because of the Virus Lockdown. Bloomberg. February 2, 2020. https://www.bloomberg.com/news/articles/2020-02-02/china-oil-demand-is-said-to-have-plunged-20-on-virus-lockdown
⁷ US kills Iran general Qassem Suleimani in strike ordered by Trump. The Guardian. January 3, 2020. https://www.theguardian.com/world/2020/jan/03/baghdad-airport-iraq-attack-deaths-iran-us-tensions
⁸ Aramco shares tumble after Soleimani killing. Energy Reporters. January 6, 2020. https://www.energy-reporters.com/production/aramco-shares-tumble-after-suleimani-killing/
⁹ ‘Dangerous escalation’ and ‘severe revenge’: The world responds to the US killing of Iran’s top general. CNBC. January 3, 2020. https://www.cnbc.com/2020/01/03/qasem-soleimani-death-world-responds-to-us-assassination-of-irans-top-general.html
¹⁰ Oil Prices Are Slow to Reflect U.S.-Iran Tensions. New York Times. January 7, 2020. https://www.nytimes.com/2020/01/07/business/energy-environment/iran-oil-soleimani.html
¹¹ The United States is now the largest global crude oil producer. U.S. Energy Information Administration. September 12, 2018. https://www.eia.gov/todayinenergy/detail.php?id=37053
¹² 1970s Energy Crisis. Wikipedia. https://en.wikipedia.org/wiki/1970s_energy_crisis
¹³ Crude Oil Brent US Dollars per Barrel. countryeconomy.com. https://countryeconomy.com/raw-materials/brent?dr=2016-01
¹⁴ OPEC reaches agreement to cut oil production to 32.5 million barrels a day: Oil ministers. CNBC. November 30, 2016. https://www.cnbc.com/2016/11/30/opec-reportedly-reaches-agreement-to-cut-oil-production.html
¹⁵ China surpassed the United States as the world’s largest crude oil importer in 2017. U.S. Energy Information Administration. February 5, 2018, https://www.eia.gov/todayinenergy/detail.php?id=34812
¹⁶ Analysis: In race for China’s crude market, Russia wins gold, yet again. S&P Global. February 4, 2018. https://www.spglobal.com/platts/en/market-insights/latest-news/oil/020418-analysis-in-race-for-chinas-crude-market-russia-wins-gold-yet-again
¹⁷ Russia comes in as China’s top crude oil supplier, ahead of Saudi Arabia. CNBC. January 24, 2019. https://www.cnbc.com/2019/01/25/russia-is-chinas-top-crude-oil-supplier-ahead-of-saudi-arabia.html
¹⁸ China oil imports from top supplier Saudi Arabia rise 47% in 2019: customs. Investing.com. January 30, 2020. https://www.investing.com/news/commodities-news/china-oil-imports-from-top-supplier-saudi-arabia-rise-47-in-2019-customs-2072571
¹⁹ Saudi Aramco bets on oil supply to Europe, trading expansion. Reuters. May 14, 2019. https://www.reuters.com/article/us-saudi-oil-aramco-europe/saudi-aramco-bets-on-oil-supply-to-europe-trading-expansion-idUSKCN1SK18E
²⁰ Russian oil flow contamination roils Europe’s refiners. Reuters. April 24, 2019. https://www.reuters.com/article/us-russia-oil-quality-idUSKCN1S01TU
²¹ Saudi Aramco Cuts All Oil Pricing for September Sales to Asia. Bloomberg. August 4, 2019. https://www.bloomberg.com/news/articles/2019-08-04/saudi-aramco-cuts-all-oil-pricing-for-september-sales-to-asia
²² Post Saudi attack, India in talks with Russia to up crude supply. Economic Times. September 17, 2019. https://economictimes.indiatimes.com/industry/energy/oil-gas/india-looking-to-raise-oil-imports-from-russia-after-saudi-attacks/articleshow/71170304.cms
²³ Want to Lose Money? Run Saudi and Russian Crude in an Oil Refinery. Bloomberg. November 11, 2019. https://www.bloomberg.com/news/articles/2019-11-11/want-to-lose-money-run-saudi-russian-crude-in-an-oil-refinery
²⁴ Sulphur 2020 — cutting sulphur oxide emissions. International Maritime Organisation. http://www.imo.org/en/MediaCentre/HotTopics/Pages/Sulphur-2020.aspx
²⁵ Saudi Arabia’s Vision 2020 (pdf). https://vision2030.gov.sa/sites/default/files/NTP_En.pdf
²⁶ Saudi Arabia’s Oil Productive Capacity: The Trade-Offs. The Oxford Institute for Energy Studies. October 2019. https://www.oxfordenergy.org/wpcms/wp-content/uploads/2019/10/Saudi-Arabias-Oil-Productive-Capacity-The-Trade-Offs.pdf see also The Saudis Have a High-Stakes Plan to Win the Global Oil War. Bloomberg Businessweek. March 18, 2020. https://www.bloomberg.com/news/articles/2020-03-18/the-saudi-crown-prince-s-plan-to-win-the-global-oil-war
²⁷ OPEC, Aramco Control Headlines More Than Oil. Bloomberg. December 5, 2019. https://www.bloomberg.com/opinion/articles/2019-12-05/opec-meeting-aramco-ipo-show-powerlessness-of-both-over-oil?sref=kOk687Pk also see OPEC Failed To Agree On Oil Cuts In Marathon Meeting But Talks Continue. Forbes. December 6, 2019. https://www.forbes.com/sites/ellenrwald/2019/12/06/opec-failed-to-agree-on-oil-cuts-in-marathon-meeting-but-talks-continue/
²⁸ OPEC, allies agree to deepen oil output cuts. Reuters. December 5, 2019. https://www.reuters.com/article/us-oil-opec-idUSKBN1Y90UK
²⁹ OPEC’s pact with Russia falls apart, sending oil into tailspin. Reuters. March 6, 2020. https://www.reuters.com/article/us-opec-meeting-idUSKBN20T0Y2
³⁰ Aramco Slashes Crude Pricing, Starting Oil War as OPEC Flops. Bloomberg. March. 7, 2020. https://www.bloomberg.com/news/articles/2020-03-07/saudi-aramco-slashes-crude-prices-kicking-off-price-war
³¹ Crude oils have different quality characteristics. U.S. Energy Information Administration. July 16, 2012. https://www.eia.gov/todayinenergy/detail.php?id=7110
³² Saudis Plan Big Oil Output Hike, Beginning All-Out Price War. Bloomberg. March 7, 2020. https://www.bloomberg.com/news/articles/2020-03-07/saudis-plan-big-oil-output-hike-beginning-all-out-price-war
³³ Saudi Arabia, Russia raise stakes in oil production standoff. Reuters. March 10, 2020. https://www.reuters.com/article/us-oil-opec-saudi-idUSKBN20X13Q
³⁴ Saudi Arabia Seeks More Supertankers to Carry Its Flood of Oil. Bloomberg. Mach 10, 2020. https://www.bloomberg.com/news/articles/2020-03-10/saudis-make-rare-supertanker-bookings-to-carry-flood-of-oil
³⁵ 2020 Italy coronavirus lockdown. Wikipedia. https://en.wikipedia.org/wiki/2020_Italy_coronavirus_lockdown
³⁶ Russian ministry, oil firms to meet after OPEC talks collapse -sources. Reuters. March 10, 2020. https://www.reuters.com/article/us-oil-opec-russia-meeting-idUSKBN20X19Z
³⁷ Japan unveils $4 billion coronavirus package, not yet eyeing extra budget. CNBC. March 10, 2020. https://www.cnbc.com/2020/03/10/japan-unveils-4-billion-coronavirus-package-but-not-yet-planning-extra-budget.html
³⁸ White House likely to pursue federal aid for shale companies hit by oil shock, coronavirus downturn. Washington Post. March 10, 2020. https://www.washingtonpost.com/business/2020/03/10/trump-oil-bailout/
³⁹ Saudi energy minister: no need for OPEC+ meet if no agreement on handling oil market crisis. Reuters. March 10, 2020. https://www.reuters.com/article/us-saudi-oil-minister-idUSKBN20X19L
⁴⁰ OPEC+ March 18 technical meeting unlikely to go ahead — sources. CNBC. March 12, 2020. https://www.cnbc.com/2020/03/12/opec-march-18-technical-meeting-unlikely-to-go-ahead-sources.html
⁴¹ see page 21 of Aramco’s Medium Term Note Prospectus: https://www.rns-pdf.londonstockexchange.com/rns/6727U_1-2019-4-1.pdf or Aramco’s IPO Prospectus (page 40) https://www.saudiaramco.com/-/media/images/investors/saudi-aramco-prospectus-en.pdf
⁴² Russian Oil Production Costs Among the World’s Highest, Aramco Says. Sputnik News. November 12, 2019. https://sputniknews.com/business/201911121077286200-saudi-aramco-russia-oil-cost-production/
⁴³ Can U.S. Shale Survive The Oil Price War? Oilprice.com on NASDAQ. March 10, 2020. https://www.nasdaq.com/articles/can-u.s.-shale-survive-the-oil-price-war-2020-03-10
⁴⁴ IEA Oil Market Report — March 2020. International Energy Agency. https://www.iea.org/reports/oil-market-report-march-2020
⁴⁵ Global Oil Storage Capacity Shrinks Amid Supply Glut. TankTerminals.com. March 25, 2020. https://tankterminals.com/news/global-oil-storage-capacity-shrinks-amid-supply-glut/
⁴⁶ Global oil storage could reach full capacity in few months. ShippingWatch. March 23, 2020. https://shippingwatch.com/carriers/article12030642.ece
