It took a global pandemic to trigger another major oil shock, akin to the historic 1973 one which was set-off by the Arab-Israeli conflict. COVID-19 forced Saudi Arabia and Russia to come together on April 10, 2020, along with the other major oil producers, to end the price war that had resulted in prices dropping to unprecedented levels. Its genesis lay in the massive increase of 3 million Saudi barrels of oil per day as a retaliation against Russia’s refusal to further cut production, as proposed by Riyadh, in the pivotal March 7, 2020 meeting of OPEC+. This had resulted in a global glut leading to a crash in crude prices.
The new deal will now shave off close to 10 million barrels of crude oil a day (mbd). A nudge from the United States (US), which had been pushing for an end to the price war in order to protect its shale industry, was a key driver in the formulation of the agreement. Ironically, Russia and Saudi Arabia had started the price war in an attempt to drive rival American shale production out of the market. Eventually, however, the prospect of a worsening economic and financial situation in both Moscow and Riyadh, as well as globally, made it difficult to prolong the price war indefinitely.
Notably, Saudi Arabia’s revenues are expected to decline by 50 per cent vis-à-vis the previous year in the event of the projected crude oil prices being in the mid-US$ 30s per barrel range for the rest of the year and even beyond. In real terms, the Saudi economy is likely to take a hit of US$ 105 billion. Similarly, Russia, though better placed than Saudi Arabia primarily due to its flexible exchange rate (as against Riyadh’s fixed rate) and a lower fiscal deficit, would also have found it difficult to absorb the decline in revenue on account of low demand for oil as well the massive price drop.
The OPEC+ deal envisages a production cut of 9.7 mbd, starting May 1, 2020, for an initial period of two months, that is, till June 2020. For the next six months, from July 1 to December 31, 2020, the cuts will taper off to 7.7mbd, followed by another tapering off to 5.8 mbd for 16 months, that is, till April 30, 2022. The agreement will be reviewed in December 2022. Of the 9.7 mbd to be cut initially, Saudi Arabia and Russia will each cut 2.5 mbd while the other OPEC+ producers are expected to account for the rest.
The OPEC+ had sought contributory cuts from both non-OPEC+ as well as Group of 20 (G-20) producers, which met a day after the OPEC+ meeting. It was agreed that the US, Brazil and Canada will contribute an additional 3.7 mbd production cut, while other G-20 nations will reduce production by 1.3 mbd. Notably, Mexico, which had initially refused to cut its allocated share of 400,000 bpd, thereby putting the whole deal in jeopardy, conceded to pump 100,000 less bpd only after President Donald Trump’s intervention.
Will the Agreement Resuscitate Oil Market?
While the agreement is being perceived as historic given the size of the cuts, whether it will be sufficient to revive the prices is a moot question.
First, a day after the deal was announced, prices moved up by two per cent. However, as Fatih Birol, the Executive Director of International Energy Agency (IEA), said during a recent interview with an Indian news channel (ET Now, April 10) that nothing less than 15-20 mbd will make a significant difference to the price. At best, the initial cut of 9.7 mbd may resolve an impending storage crisis, and even stop oil prices from falling into single digits. But with the global economy showing no sign of recovery for the rest of the year, the lack of demand is unlikely to allow prices to go past the $40/barrel mark.
Second, the commitments to cut production by 3.7 mbd made by non-OPEC countries like the US, Brazil, and Canada are non-binding, given that oil production in these countries are privately owned and not under government regulation, and may not translate into actual reduction in output. These producers are likely to push for the ongoing decline in their production, on account of a fall in demand, to be accepted as the allocated production cuts. Canada, for example, has stated that its production has fallen by 800,000 b/d. Similarly, American production has declined by 2 mbd due to the closure of several shale firms who have found the low oil prices unsustainable.
Third, the cuts will have to be sustained for several months, perhaps even a year, before the huge inventories built up by several countries can be exhausted and prices begin to go up. However, with the global economy ravaged by the pandemic, a fact highlighted by the International Monetary Fund (IMF) Chief Kristalina Georgieva, it is unlikely that demand will increase sufficiently to wipe out the crude stock. According to some analysts, the loss in demand is likely to be 30-35 mbd from the daily demand of 100 mbd. With global inventories at an all-time high and a low demand, it is likely that stocks will get reduced only after several months.
Fourth, the current supply/demand imbalance, as per the OPEC Secretariat’s assessment, can lead to an excess volume of 14.7 mbd in the second quarter of 2020. Given that the global oil storage capacity stands at over 1 billion barrels (bb), the excess volume can add another 1.3 bb to existing global inventories. Arguably, the spectre of the world running out of oil storage space was a major factor that triggered the truce between Moscow and Riyadh.
Notably, on April 16, Saudi Arabia and Russia have indicated that they may consider further cuts after the historic deal to curb production failed to stem the crash in prices. In fact, since then, the oil prices have plunged by more than 20 per cent (Brent) while the US benchmark West Texas Intermediate (WTI) futures even traded, albeit briefly, at (minus) -$37 per barrel on April 20 – the biggest drop in its history driven by technical and timing issues over contract deadlines – amidst reports of lack of storage and a massive supply of Saudi crude being headed for the US.
This raises the question of the fallout of the crisis once the dust settles. According to veteran oil analyst Edward Morse, the future can be “a benign low cost price arena or a higher cost politically charged one.” A new order can even be in the offing particularly when the position of the US as the world’s leading oil producer is being increasingly challenged.
Time for a Larger Market Re-balance
It is, therefore, apparent that while the over-supply in the market has caused some damage, the real cause of the current crisis has been the lack of global demand for oil. The prospect of an early recovery appears unlikely till at least the third financial quarter with the COVID-19 virus showing little signs of retreating.
Prior to the current crisis, the largest on record decline in oil demand had been a 10 per cent drop between 1979 and 1982. It is now projected that as much as 20 per cent of the global demand can be wiped out over the next few months. Much of this is due to the lockdown in the transport sector, as commercial flights have been grounded, and road and rail traffic restricted with several countries ordering their citizens to stay at home. India, the world’s third-biggest consumer, has seen its demand for oil collapse by around 70 per cent or 3.1 mbd. A similar trend has been observed in several major European economies.
However, amidst all the doom and gloom, there exists a silver lining, at least for the big oil importing countries like India, even though the current price shock is a mixed bag. While the Indian upstream companies are facing a demand crunch leading to a fall in production, the oil marketing companies and consumers are benefiting from the sustained low-price environment. The Indian Government, meanwhile, has used the opportunity of rock bottom prices to fill its strategic inventories even as the country’s oil import bill has been substantially reduced.
Most importantly, the prevailing environment has underlined the importance of a balanced market to the oil producers. India has been consistently reiterating the need for oil to be priced responsibly in order to ensure the stability of the oil market. The G-20 meeting held in April 2020 had also highlighted the need for a modus vivendi between the producers and consumers in order to ensure a healthy balance between the demand and supply of oil.
The pandemic, therefore, has underscored a stark reality for oil producers that in the current environment where the very future of oil is being debated, there is no energy security for them without adequate and sustained demand.
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