Thursday, September 24, 2020
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To Cut or Not to Cut?

Today you need to fish for good news if you want to uplift your mind and spirit. One could be that the gasoline price is lower and lower every week; however, it is impossible to take advantage of that as we are not driving anywhere during the lockdown. I haven’t filled my car for three weeks now. This is exactly what causes the problem in the oil market. When Russia didn’t agree to the OPEC proposed production cut in early March, and as a reaction, the Saudis started to increase their oil production to a record high of 12 million barrels per day (mbd), the dramatic impact of COVID-19 for the economies of the US and Europe wasn’t yet visible.

The heavy supply push got accompanied by an unprecedented demand decrease. Projections vary but for April demand could fall by up to 16-30 mbd which is about 16-30 per cent of last year’s average daily global consumption. President Trump is urging the Saudis and Russia to cut the daily production in-between 10-15 mbd. If you do the math, this will be far from enough to balance the market in the short term.

The US, Russia and Saudi Arabia are all losing greatly in the price war. The price of oil is way below the breakeven cost of several US producers. The breakeven price for US producers on average is around 45 US dollars/bbl. The price of oil was lower than this even on March, 6, before the supply push by Saudi Arabia and demand collapse due to the corona pandemic in the US and Europe. It was traded at 41 US dollars/bbl then. There has already been a US company file for bankruptcy last week, Denver-based Whiting Petroleum. In the US there are over 6000 producers – independent ones and the likes of ExxonMobil and Chevron – and it’s almost impossible to create a unified position among them unless state regulators use their authority to pro-ration production. On Friday, the US President had a closed-door discussion with CEOs of American oil majors; however, very little came out of it other than consideration of tariff or retaliation of sort. There are no clear answers to what’s ahead.

For the Saudis, the price war could hurt the most even in the short term. The oil sector accounts for 40-42 per cent of the GDP and 85-90 per cent of the budget revenues. Even if the Saudis have a lower cost of production, their breakeven fiscal price for the budget is 80-85 US dollars/bbl. If oil stays at around 30 US dollars/bbl throughout 2020, the projected budget deficit could reach 10-12 per cent. Even though 30 US dollars/bbl looks like a dream scenario for the producers today(!), the price war also strained the Kingdom’s relationship with the US, it’s a major Western ally. In a US election year, it cannot risk stretching it even further. Riyadh is also putting its relationship with other OPEC countries at risk who are also losing substantial revenues now to cope with the coronavirus.

Maybe Russia has the least to lose in the short run. Russia has been doing serious structural changes in the last few years, the result of which is its breakeven fiscal price for the budget of 42 US dollars/bbl. The oil sector accounts for 10-15 per cent of their GDP and 35-40 per cent of the budget revenues. If oil stays at around 30 US dollars/bbl in 2020, Russia loses about 1-2 per cent of GDP. It also has the fourth-largest international reserves with 580 billion US dollars. With ruble devaluating, Russian oil is becoming even more competitive in the short run. President Putin, as well as many in his administration and Russian oil companies, signalled a sort of readiness to conclude a deal. But as Russia is the least affected by the actual situation, we should expect President Putin to ask for high concessions and, in particular, some sanctions to be removed.

Production is destined to fall in all three countries. At today’s prices and even in case of a significant rise from the 20s US dollars to the 30s US dollars, US producers would continue to struggle. Companies have already started spending cuts which will inevitably lead to production decrease. Plus, today the bottleneck is increasingly the infrastructural constraint of the storage and pipeline capacity which would lead to further production decrease. With the global demand decrease all producers and, in particular, the top three, will also encounter challenges such as where to place their oil. In that case, a supply cut would inevitably follow.

The challenge today is not to stabilise the oil prices at a much higher level for the second quarter. It is to prevent prices from falling even lower and avoid costly and damaging shutdowns once storages are full and the market cannot absorb more oil. Shutdowns are much more costly than a decreased production is as certain oil fields could be permanently damaged if the ramp down is not scheduled carefully. The aim should really be to flatten the curve of prices so that companies have enough time to prepare. Because of the sharp demand decrease, supply would have been curtailed sooner rather than later. Producers are already struggling to place their product on the market. It would be more productive in the long run to embrace the inevitable and announce global cuts this week. That way the big three could project control, leadership and goodwill to cooperate in stabilising the oil market.

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