By: Sophie Chardon, Senior Cross Asset Strategist, Banque Lombard Odier & Cie SA
Monday, 9 March saw oil prices plunge, recording a ~30% fall over the day. Behind this market turmoil was the unexpected collapse of the OPEC+ alliance with Russia after an inconclusive meeting on the preceding Friday.
On Thursday, 5 March, OPEC members had seemingly agreed on further production cuts to mitigate the short-term negative impact of the COVID-19 outbreak on oil demand (chart 1).
Indeed, both the IEA and OPEC have revised down their estimates for oil demand growth to near zero in 2020. This initial move – although conditional on additional cuts by OPEC+ members (mainly Russia) – was actually in line with the market’s and our expectations. Estimates of cuts needed for the coming months were around 1-1.5 Mb/d. The OPEC+ meeting during which Russian and OPEC members failed to reach an agreement on production cuts thus came as a big surprise. Saudi authorities retaliated over the weekend by offering their European and Asian customers a significant discount on their Official Selling Prices (OSP) for April, starting a price war amongst oil producers.
What does this mean for the short-term market balance? – An outsized oversupply and rebuilt inventories
At a time when the world is facing a (short-lived) demand shock, this price war will translate into a sizable oversupply. In a price war, producers aim to produce as much as possible in order to ensure their market shares. Given the Saudis’ production capacities, they appear well placed to benefit from this new order (chart 2).
As of now, we estimate that the oversupply should be approximately 2.5Mb/d in the coming months. This is already a large oversupply by historical standards, but the situation could worsen materially, and reach 5 Mb/d if all producers maximise their spare capacities. Initially, Saudi Arabia had planned to raise its production to above 10Mb/d in April, but the price war escalated on March 10 (at least rhetorically) when Saudi Aramco pledged to supply a record 12.3 Mb/d. Russian authorities retaliated within minutes, claiming they had the ability to boost production by another 0.5 Mb/d that would lift the country’s output to a record high.
Is the market overreacting? – No
As experienced in the past, periods of large oversupply on the oil market have been followed by a sharp fall in oil prices (chart 3), to the tune of 20-40% depending on the demand backdrop.
We can identify two periods with oversupply close to 5Mb/d. First, in 1998, the lower demand triggered by the Asian financial crisis saw the price of oil down by over 30%, falling back to 1986 levels. In 2015, it lost 45% after OPEC decided to set aside its ineffective production ceiling against another oil glut engineered by both a slowdown of the Chinese economy and the expanding US shale industry’s output. What was particularly striking this time was the abrupt market reaction, with an extraordinary daily move that can be characterised as a “Black Swan event” from a risk management viewpoint.
The collapse of the OPEC+ alliance is a game-changer; new 12-month target:$40/bbl (Brent)
For several years now, OPEC+ was credible in our eyes for the central bank role it sought to play. By maintaining a floor on prices while recognising that a too-elevated price was detrimental to demand, the Organisation sought to ensure a more favourable environment for investment in long-term projects. It was rather active and successful in this undertaking. Thus, the end of the three-year partnership between Russia and Saudi Arabia is a game-changer for the market structure, as it brings us back to a more traditional playbook, with low-cost producers increasing supply from their spare capacity to force higher-cost producers to reduce output. While we cannot rule out an OPEC+ deal in the coming months, in this new context, the fair value of the oil price should be close to the industry’s marginal production cost, which is estimated at around $40/bbl.
The oil market now faces two highly uncertain bearish shocks on the demand and supply sides of the equation. While demand should reaccelerate in the second half of the year, we would not be surprised to see prices evolving around $30/bbl in the coming months, with the clear risk that prices at times will overshoot to the downside if the newsflow on the coronavirus fails to improve.
How long can this situation last, and what are the consequences for the oil industry?
First, from a fundamental standpoint, depending of the level of the inventories built, it might take several quarters or years to clear the market, especially in a growth environment. Second, from a geopolitical standpoint, if one of the motivations of Russia for this price war is to hurt the US shale sector, it would make sense to maintain prices just below where they would undermine shale production for an extended period.
While this will be beneficial for net importers such as the euro area and China, it will pose risks for oil-exporting countries that will be forced to cut public spending and to the US shale sector where companies may face serious default risk.
Even if the fiscal breakeven points of Russia and Saudi Arabia (i.e. the oil price level required to balance their budgets) are much higher than our $40/bbl target, there is still fiscal space in both countries (chart 4).
Their public debt is clearly much lower than developed markets’ – and at the lower end among their emerging market peers. These two major oil-exporting countries have thus the ability to withstand a prolonged period of low oil prices.
By contrast, for shale and other high-cost producers, such price levels of $40/bbl and below will begin to create acute financial stress and reduce their production. With marginal cost of production estimates in the $45-50/bbl range, some companies have already announced they will be forced to shut down some rigs that are economically inefficient (chart 5).
Obviously, the longer the low-price environment endures, the deeper the pain inflicted on the US shale industry. US high-yield energy credit spreads were already above 1,000 bps in late February; the last time they had traded at such a level was March 2016 when WTI prices hovered at $35/bbl. They are now above $1,400 bps, pricing in a material default rate. Meanwhile, it may be worth keeping in mind that the large refinancing needs of shale companies will materialise mostly in 2021-22, and that we should expect some support from the US administration to provide the sector with the necessary liquidity given the strategic positioning of shale.
More generally, one should expect investment in long-term projects to be postponed or cancelled in this new oil price environment.