Kayrros Round-Up: OPEC’s Red Monday

Oil prices collapsed over the weekend after OPEC and Russia failed to deepen their production cuts in the wake of the coronavirus and Saudi Aramco set off an all-out price war by slashing its Official Selling Price. The market was evidently taken by surprise by the breakdown of the Saudi-Russian alliance and the reversal of their production policy of the last few years. Yet there were elements of continuity and predictability in the decision.

Last week, in a commentary for Columbia University’s Center on Global Energy Policy, Kayrros chief analyst and co-founder Antoine Halff raised the prospect of a no-deal OPEC meeting and of a return to market share policy. This was due — at least in part — to the sheer scope of the supply cuts needed to offset the effect of the coronavirus. Saudi Arabia’s prospects of convincing Russia to share the burden seemed bleak and its willingness to shoulder it singlehandedly seemed equally doubtful since it would have meant returning to production lows unseen since the 1980s — and that Riyadh in the past had pledged not to revisit.

Kayrros also published a piece in December hinting at a no-deal OPEC scenario. The study leveraged the oil market modeling of Kayrros cofounder Jean-Michel Lasry and Fields Medal recipient Pierre-Louis Lions. Lasry’s game theory-based model also suggested that the oil market was ripe for a correction and that the “dominant monopoly” of large, low-cost producers would return to a market share strategy. Despite OPEC rhetoric about oil-price stability, it is clear that the producer group has for decades engaged in a balancing act in the pursuit of two conflicting goals: high prices and market share. The logic of revenue optimization dictates that OPEC should periodically let prices drop, usually in reaction to some kind of market shock, to undermine higher-cost competitors and regain market share lost during periods of production cuts. In this case, the pattern is familiar, but the nature and the magnitude of the market shock are unprecedented. We don’t know how long the demand shock due to the novel coronavirus will last, but its steepness is record-breaking and OPEC’s return to high production will amplify it further.

This shift to market share strategy is being felt in every corner of the energy market. So, in this report, we conduct an informal conversation with Kayrros analysts from around the globe to gather their insights and consider some of the potential impacts of the Saudi decision to raise output. We start with Singapore-based analyst Alexis Berson.

Alexis, COVID-19 drove the demand shock which brought OPEC to the table. China was obviously the first and, for now, the most impacted demand region. What is Kayrros seeing in Chinese crude inventories?

Alexis Berson, Market Strategist, Singapore: Chinese demand and inventories

Kayrros detected early signs of crude demand decline as fears related to COVID-19 mounted, especially in China which drives 75% of overall crude demand growth. Kayrros measured a build of 13 MMb in Chinese crude stocks in the first half of February followed by a jumbo build of 28 MMb in the second half of the month. Such a one-month increase in China inventories (+41 MMb!) has never been seen before.

Interestingly, the effect of the coronavirus outbreak did not translate immediately into crude builds as storage was almost flat in January. Taking also imports into consideration, the Kayrros implied demand calculation for China showed a massive decline of 4 MMb/d compared to baseline levels. As Aramco CEO Nasser announced plans this morning to increase production to 12.3 MMb/d in April, it will be crucial to keep monitoring Chinese inventories.

So, we were already seeing unprecedented builds in Chinese crude stocks before the Saudi announcement that they’d increase output. Laila, will the Saudis have any issues ramping up to the 12 MMb/d that they promised? How much capacity does Aramco have today?

Laila El-Ashmawy, Market Strategist, New York: KSA inventories

In terms of production, Saudi Arabia is certainly able to ramp up output to at least 10 MMb/d in the short term. Whether they can reach more than 12 MMb/d in just a month is less clear. Kayrros estimates January and February production averaged as high as 9.5 MMb/d. Exports fell more sharply than production, and we’ve seen this through building crude oil inventories in the country. In February, crude storage held within the Kingdom reached its highest level since November 2018. There is a roughly 15 MMb cushion (from the lows measured in November 2017) in storage which can lift exports immediately. The extra capacity is concentrated in the country’s western ports near Yanbu. In the East, there is much less capacity in storage, but demand from China absorbed most of the exports from Saudi Arabia’s eastern terminals. Ras Tanura has drawn 175 kb/d since the beginning of February and storage in Ras Tanura is at its lowest levels since Kayrros measurements began in 2016.

Saudi Arabia historically claimed a production capacity of more than 12MM b/d, but an attack on their production facility at Abqaiq has the market wondering if they could still achieve that kind of output. Badr, your Kayrros Rapid Response team monitored the damage and repairs at Abqaiq back in September. Are those facilities back to normal? Is there anything keeping Saudi Arabia from ramping up to full capacity?

Badr Ben m’barek, Product Manager, Paris: KSA production capacity

Regarding Abqaiq, the processing capacity of the facility had previously recovered to about 72% of its total capacity within three weeks following the attacks. By January 12, there was still ongoing work at the northern stabilization towers, which was the most damaged part of the facility, while what appeared to be a temporary worker’s camp was still present on-site. We’re expecting new high-resolution satellite imagery of the facility in the coming hours and we’ll soon update our clients on whether or not the 7MMb/d facility is 100% operational.

There appears to be no shortage of supply from the Saudis, but what about downside risk to supply from other producers? Ted, the latest developments have been framed in some quarters as OPEC and Russia targeting US Shale producers. How do those operators react in this price environment?

Ted Hall, Market Strategist, Houston: US tight oil operators

At a high level, this all feels very familiar to those of us who were covering this market back in 2014, but there are some key differences from the last time we found ourselves on this roller coaster ride. US operators aren’t the same animals they were in 2014. During that downturn, US tight oil operators learned a lot of lessons. They got leaner, they drilled better wells, they made fewer long-term commitments to services and midstream, and they got much, much faster.

Even as the number of active rigs and fracs has fallen substantially over the past year, the number of wells coming online hasn’t dropped nearly as much. In the Permian, that number is barely down at all. The most important difference in US operators between 2014 and today, however, is their investors.

E&P equity investors demand fiscally responsible drilling. They demand free cash flow. And last year operators really started to listen to that mandate. That was simply not the case in 2014 or 2015. Today, because they’re newly focused on returning capital to investors, operators will act more quickly and decisively to tighten their belts. We’ve already seen Diamondback announce yesterday morning that they’re dropping crews and they won’t be the last. If the market remains this oversupplied, US production will begin to fall and it won’t take the same six months it took back in 2014.

Ted brings up an interesting comparison — and contrast — with 2014 and 2015 when Saudi Arabia ramped up production to regain market share. But the downturn in the second half of 2014 also came at the end of a period of very tight global oil balances following the Arab Spring. Augustin, when you look at storage, how does today’s market compare with where we were in November 2014?

Augustin Prate, Product Manager, Paris: Prices and global inventories

What’s happening — Saudi Arabia ramping up production to regain market share — certainly bears resemblance to 2014, which means there’s room for further downside on prices. There’s a pretty significant contrast to 2014 on a global scale as well, however. Two main differences:

First, the November 2014 OPEC meeting was a reaction to growing supply from the US and Libya. Deciding then to raise output was a supply shock, but demand reacted strongly, growing at a rate of more than 2 MMb/d in 2015 and 2016. Today? What the market is facing today may be unprecedented: an OPEC supply shock on top of a rapidly developing demand shock from coronavirus. Saudi Arabia potentially needed that combination to ensure impact, as OPEC market share (without Russia) is lower than it was in 2014.

Secondly, global inventories are at a much different starting point than in 2014. Today inventories are at a much higher baseline level, leaving much less cushion for a market so oversupplied. Current global inventories actually look much more like they did at the end of 2015 and beginning of 2016, when Brent prices bottomed out at $27.

With so much uncertainty ahead in a rapidly changing oil market, the ability to monitor events in realtime is as important as ever. The Kayrros team of analysts will stay vigilant in the coming months, monitoring changes in inventories and production on a global scale. The Kayrros Rapid Response team also stands at the ready to react to the next major shift, whether it’s measuring economic activity in COVID-19 affected regions or monitoring production and refining facilities after a disaster.