Big oil meltdown

oil meltdown

A clash of two oil titans — Saudi Arabia and Russia — is sending shock waves through energy markets, with wide-ranging implications for consumers and oil companies, including those in the No. 1 producing country, the United States. The spat between these vital oil suppliers comes at a critical moment; the coronavirus outbreak is squeezing economies around the globe to the point where world oil demand is forecast to shrink in 2020 for the first time since 2009.

On March 9, oil prices fell by the most in one day since the 1991 Gulf War. The price of US crude fell as much as 34% to $27.34 a barrel, a stunning drop for one day and the lowest price since early 2016. The decline followed Russia’s refusal to join the OPEC oil cartel in proposed production cuts aimed at supporting prices. Thwarted in its search for cuts, Saudi Arabia, the leading OPEC member, sharply changed course over the weekend by cutting prices and signalling it will ramp up production.

Fencing Market

First came the coronavirus outbreak, which reduced travel and transport, sharply reducing demand for fuel. The international Brent benchmark had fallen from $69 at the start of the year to around $50 last week. Then came last week’s meeting between OPEC and non-member countries. On the agenda: a production cut of 1.5 million barrels a day, or about 1.5% of global production. The idea was to keep prices from sagging even more as demand is expected to fall this year.

Saudi Arabia, the world’s No. 2 oil producer, wanted No. 3 Russia and other non-members to take 500,000 barrels per day of the cuts. But the Russians balked. They refused to join new cuts, or even to extend previous production cuts that were due to expire at the end of March. The Saudis hit back, telling customers that they were going to ramp up production and slash prices for Asian customers.

Saudi Arabis’a goal is to protect market share. Both Saudi and Russia have seen US producers take a chunk of their market, and falling prices help keep customers on board.

Second, Saudi Arabia may hope that the pain of low prices will force a Russian rethink. “Saudi Arabia has de facto launched a price war against Russia, promising to sell its oil at a discount in order to maximise its oil revenues,” say analysts at UniCredit bank. “It appears Saudi Arabia wants to cement its position as the world’s top oil exporter and to persuade Moscow to return to the negotiating table.”

Russia’s Refusal

Russia may have seen no point in cutting production only to lose market share as US shale producers in Texas and New Mexico take up the slack. Analysts say Saudi Arabia may be underestimating Russia’s ability to weather low prices. Both countries are heavily dependent on oil revenues for their state budgets. But Russia says it can balance its budget at around $42 a barrel for its own benchmark crude. Saudi Arabia, whose economy is less diverse, needs more than $80 per barrel, according to the International Monetary Fund, even though its costs are much lower than Russia’s.

What Saudi Arabia has done is to send prices so low that both will feel a serious crunch. And Russia may have a longer-term target: the US oil industry. “The Russians are doing this out of long-term strategic considerations,” said Tom Adshead, research director for the Macro-Advisory consulting firm in Moscow. “Their view is that by doing this they can damage the financial health of US shale-oil producers and that by doing this they can take a lot of US capacity offline and thereby remove US producers as a source of competition. The other thing that is on their mind in all this is that if they cut then that will also primarily benefit US producers.” “So they’ve decided they’re going to take some short-term pain in order to inflict damage on one of their major competitors,” Adshead said.

Stephen Innes, chief market strategist at financial services firm AxiCorp, says Russian President Vladimir Putin may also have decided to hit back at the U.S. industry after Washington placed sanctions on Russian state oil company Rosneft for marketing Venezuela’s oil.

oil meltdownImpact on US Producers

The current low prices could constrain activity in the American shale oil industry. A downturn in oil prices in 2014-2016 hurt companies in places like the Permian Basin in west Texas and eastern New Mexico. According to the Federal Reserve Bank of Dallas, $50 per barrel is the price at which it becomes profitable to drill a new well in the US. Large producers such as Exxon have already scaled back with prices at $50 a barrel. In Texas, the number of active rigs fell from 553 in October 2018 to 398 in January 2020. Around the same time, the oil industry in Texas shed about 14,000 jobs.

“With the growth phase of the shale boom grinding to a halt due to the lack of investment in the industry, now US shale oil could find itself running into a brick wall,” says Innes from AxiCorp. The head of the International Energy Agency, Fatih Birol, believes the US shale industry will survive but the risks are high. He warned countries against being rash with big production decisions: “This is not a Russian roulette.”

India to Benefit

The Indian economy will likely see significant benefits in the form of lower current account deficit, reduced inflation and higher GDP following a slump in international crude oil prices, Kotak Institutional Equities Research said. With coronavirus already savaging demand for travel and transportation, “the world is now drowning in a glut of crude oil that appears likely to persist for months,” said Chris Lafakis, Energy Economist at Moody’s Analytics.

For India, this may be a boon to pull out the economy from an 11-year low growth rate and rising inflation. “Lower oil prices provide significant tailwinds to the Indian economy in the form of lower current account (50 basis points of GDP or USD 15 billion for every USD 10 a barrel decline in crude prices), lower inflation (30 bps for every USD 10/bbl fall) and improved government finances/household savings,” said Kotak.

Lower crude prices will benefit automobiles (lower cost of ownership), aviation (lower fuel bill), cement (lower pet-coke prices), consumer companies (lower packaging costs), city gas companies (lower gas prices), oil marketing companies (higher marketing margins on automobile fuels) and paints, it said. However, upstream oil and gas companies such as Oil India and ONGC may make losses if net realised price is below USD 35 per barrel, it said. Even if the coronavirus scare fades, excess supply from Saudi Arabia and Russia will persist.

Supply Glut

The UAE national oil company said on March 11 it was ready to boost its oil supplies by around one million barrels per day as a price war with Russia simmers. “In line with our production capacity and growth strategy … we are in a position to supply the market with over four million barrels per day in April,” Abu Dhabi National Oil Co. said in a statement. “In addition, we will accelerate our planned five million bpd (output) capacity target,” the state-owned firm said.

The United Arab Emirates’ move mirrors that of Gulf ally Saudi Arabia in flooding the markets with millions of barrels of oil to secure market share after a production cut agreement with non-OPEC producers led by Russia flopped on Friday.

Saudi Arabia announced plans on March 10 to raise its production to 12.3 million bpd, effectively increasing its supplies by 2.5 million bpd and escalating its price war with Russia. The UAE currently pumps around three million barrels per day but it has earmarked more than $132 billion in investments to raise its output capacity to 4 million bpd this year and to 5 million bpd in a decade’s time.

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