Primum Non Nocere: About the Chances to Normalize the Situation in the Oil Market

The peculiarity of the current situation is that the world immediately faced three crises that coincided in time.

Measures to limit the movement of populations between and within countries due to the COVID-19 epidemic, which are implementing quarantines worldwide before our eyes, have led to an unprecedented slowdown in economic activity and the beginning of a global economic recession. The peculiarity of the current situation is that the world immediately faced three crises that coincided in time: a global pandemic; an exceptionally acute structural crisis in the oil and gas markets, related to both the accumulated distortions in the supply structure and the threat to hydrocarbon demand posed by a radical transfer to carbon-free energy sources; and, finally, the aggravation of the geopolitical rivalry between the great powers, which has led to sanctions and trade wars. Each of them in itself poses a threat to economic growth, but their combination has had the effect of a “perfect storm”; the most serious economic challenge to mankind since the Great Depression of the last century.

For a doctor, the first rule in the treatment of a patient is “first of all, do no harm” or primum non nocere – the essence of the Hippocratic Oath taken by doctors since classical antiquity. The world economy is now the same patient; structural imbalances that have appeared during the crisis took a long time to develop, they require urgent, but at the same time delicate treatment. Unfortunately, we see that the struggle that has unfolded since the beginning of March for the re-division of the world oil market violates the Hippocratic Oath. Instead of being part of the solution to the crisis, the global oil industry and its main players have become part of the problem.

Oil prices collapsed from levels of about $70 per barrel of Brent mix at the beginning of the year to $20 by the end of March, which is below the critical level of short-run marginal costs for many global producers. In the US physical market, cases of negative prices have already been recorded for a number of regions that are far from consumers and lack storage facilities, for example, for sour bituminous oils (Wyoming Asphalt Sour). In some regions, barrel prices for off-spec types of oil cannot rise into the double digits (Oklahoma Sour). If this situation lasts several months, it will inevitably lead to widespread collapse among oil and gas companies and other sectors included in the associated value chains, prompting layoffs and unemployment, which will create additional problems for many countries that are struggling with the COVID-19 pandemic.

Was it possible to avoid a “hard landing” and panic in the market? History does not know what could have been, but undoubtedly, if the OPEC + deal hadn’t fallen through, the economic damage to the world oil industry would have been far less severe. What happened, and is there any chance that Saudi Arabia and Russia, the key members of OPEC+, will undo what’s done?

As you know, the OPEC + summit in Vienna on March 5-6 was held in the context of growing concern that the COVID-19 epidemic in China could develop into a global pandemic. Projections of a serious slowdown in economic growth in the world had already appeared, but the true scale of the crisis at that moment had not yet manifested itself. This, apparently, played a fatal role. The members of the alliance did not agree on the need for a new reduction in production by 1.5 million barrels per day in addition to the restrictions that existed at that time (proposal by Saudi Arabia). The option of extending the extant reduction in production through the second quarter of 2020, in order to better assess the magnitude of the impact of the epidemic on world oil demand (an alternative proposal from Russia), also did not find general support. Pavel Sorokin, Deputy Minister of Energy of Russia, who was an active participant in the negotiations, in his recent interviews spoke very diplomatically about the disagreements between the participants, calling them “different points of view” and “a different approach to solving the problem.”

Oil Wars: A Zero-Sum Game

Judging by the loud “banging of the doors” at the end of the negotiations, and the announcement of Saudi Arabia that it would withdraw from the agreement from the beginning of April and offer huge price discounts to its oil buyers this month can only be interpreted that the OPEC+ meeting had ended in utter failure. The Saudis delivered an ultimatum to Russia, and when their pressure tactics didn’t work, they defiantly left the deal. Saudi Arabia has announced that it will now use its free production capacity, which, according to various estimates, can be up to three million barrels per day. In other words, it announced the beginning of the war for market share. This has created a threat of a serious supply surplus.

At the same time, during March there was a constant revision of the scale of reduction in demand for oil and oil products as the coronavirus epidemic spread to new countries. Currently, the reduction in oil demand in April is estimated at 16-20 million barrels per day (i.e., about 20% of global demand), and for the whole year – at 5 million barrels per day. This is the most serious decline in oil demand this century. Obviously, if OPEC+ agreed to lower production by 1.5 million barrels per day in early March, this could only have a homeopathic effect. The inventory of oil and oil products would still grow very quickly, and the threat of the most easily accessible oil storage tanks being filled could only be delayed, but not prevented. What could and should have been avoided was panic in the market. The Russian proposal to extend the OPEC+ agreement, pending the clarification of the situation with the epidemic (with the possibility of convening an extraordinary session of the organisation) allowed this. Unfortunately, what happened happened. In a falling market situation, loud statements about increased production and a quick victory in the price war led to a panic and such collapse in prices, which, according to Leonid Fedun, vice president and one of the main shareholders of LUKoil, proponents of a breakup agreement could not have imagined “even in their worst nightmare”.

The above does not mean at all that the positions of Saudi Arabia and Russia were irrational, or that the inability to agree was caused by personal ambitions and the inflexibility of the negotiators. There are objective restrictions for reducing production, and they are different for different countries. From a technological point of view, it is Saudi Arabia that can relatively easily balance the volume of its production, due to both the presence of gigantic deposits and the concentration of production in the hands of the state-owned company Aramco. Tight oil producers in the US can also quickly balance their production by cutting back on new drilling and hydraulic fracturing operations, but the problem is that numerous companies do not coordinate actions among themselves; moreover, this is expressly prohibited by the American antitrust laws. Russia is not the so-called swing producer, from a technological point of view, the shutdown of many existing wells in Russia could lead either to a serious reduction in future production rates or to irretrievable production losses.

Of course, looking back to what transpired a month ago, we can say that both sides had miscalculated in their assessment of the short-term drop in demand and the likelihood of the market to panic. But even if this factor played a role, it was not the main one. During the operation of the OPEC+ agreement, numerous imbalances in the global oil industry were not only not corrected, but also began to grow again. The principle imbalance is that “the period of record low (interest) rates in developed economies created an unprecedented distortion of economic reality, reducing the discipline of investors in choosing projects, starting the investment cycle in absolutely unprofitable projects” (from a Reuters interview with Pavel Sorokin on March 11, 2020).

Over the past ten years, the largest increase in oil production in the world has been due to American producers of tight oil: the US “shale revolution.” Since the start of the OPEC+ agreement in 2017, US oil production has grown by 4 million barrels per day and has “eaten up” the entire incremental increase in world oil demand over this period. Each new decline in production within OPEC+ has maintained prices at a level that has allowed US manufacturers to remain in the market and expand their share. In addition to shale oil, investments in expensive oil projects in Canada, Mexico, Brazil, as well as in deep-sea projects, i.e. long-cycle investments, have begun. Many market participants have decided that OPEC + would protect the lower price level and began to invest in high-risk adventures. All this has happened against the backdrop of intensified discussions about the need for a quick and radical transition to carbon-free energy to prevent global warming and irreversible climate change. The question that arose was if countries that own vast oil reserves, such as Saudi Arabia, would have enough time to monetise them.

It seems that Saudi Arabia felt that the OPEC+ agreement had become a trap for it, which slowly but surely worsened its strategic position and deprived it of ways to influence the situation. The Saudi policy began to change, and there were clear signals that they were preparing to bet on the growth of their market share. In December 2019, the initial public offering of a 1.5% stake in Aramco took place, which was one of the ways to monetise oil reserves, as well as a signal that the company had begun to reorient its priorities from satisfying the budgetary needs of the Kingdom to maximising profits. After almost 50 years of negotiations, an agreement was reached with Kuwait on oil production in the so-called “neutral zone” on the border of the two countries, which will increase production by 0.5 million barrels per day. Saudi Arabia also plans to actively increase natural gas production for use as fuel for its power plants, and this will free up large volumes of oil for export (Saudi Arabia is one of the few countries that still use oil as fuel for electric power generation).

In relation to the March OPEC+ meeting, the fundamental reason for the disagreement was as follows: Russia was satisfied with the long-term price range of $40-50, which would inhibit the emergence of new projects with high production costs, while these prices were not enough for the budget of Saudi Arabia. Despite the very low costs of oil production in the Kingdom, its budget depends on high oil prices. This year, according to IMF estimates, Saudi Arabia requires that a barrel of oil cost 83.6 US dollars in order to maintain a deficit-free budget. In recent years, market prices have been significantly below this level, which has forced the kingdom to spend huge amounts of foreign exchange reserves (more than $400 billion over the past five years) to finance the budget deficit. Unlike Russia, which solved this problem through the large-scale depreciation of the ruble and active import substitution, especially in the food market, the rial to dollar exchange rate has remained fixed for all these years, reflecting the huge dependence of Saudi Arabia on imports of equipment, technology, and consumer goods.

The Saudis have made several attempts in recent years to test their competitors’ ability to survive at low prices. Apparently, Saudi Arabia’s bet on another “blitzkrieg”, a lightning war that will force other high-cost producers to sharply reduce production and lead to subsequent price increases, is based on the belief that in 2020 it will have long-term success, unlike the situation in late 2014 and early 2016, when US production quickly recovered from the fall.

The problem is that the Kingdom has chosen the most inopportune moment for revenge. The outbreak of war for the redistribution of markets amid the unfolding coronavirus pandemic looks inappropriate at best, and at worst, resembles a deliberate provocation. Moreover, it is “worse than a crime, it is a mistake.” The scale of the fall in prices is so large that it covers a possible increase in sales in the short term, and the risk that this strategy will fail to result in a long-term increase in market share are great. In practice, the Saudis have already faced the fact that oil refineries in Europe refuse their oil (despite huge discounts) simply because there is currently no demand for oil products, and it is not clear when this demand will return.

Under these conditions, responsible politicians in Russia and Saudi Arabia may recall the Hippocratic Oath and suspend previously-announced plans to increase production. This will not repair the situation (the drop in demand is too large), but at least it will not make it even more tense. There were hopes that the virtual online meeting of the G20 leaders, organised by Saudi Arabia on March 26 as the organisation’s chairing country this year, would enable the United States, Russia and Saudi Arabia to announce that they’d agreed upon measures that would normalise the situation on the oil market, but this did not happen. The Saudis obviously want to avoid losing face and are not ready to discuss a unilateral disproportionate reduction in production. The US is not ready to apply direct regulation to its oil companies. Russia apparently believes that until the bottom of the fall in demand is reached, attempts to rectify the situation by regulating supply will remain ineffective.

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Now the fate of the oil market depends mainly on how quickly it will be possible to overcome the COVID-19 pandemic. It seems that if oil prices remain at levels no higher than $30 per barrel over the next few months, the “invisible hand” of the market will force the United States to assume the main burden of balancing supply, i.e. the situation witnessed in 2016 will repeat itself: amid conditions of record low prices and given a serious reduction in investment, the pace of oil production in the United States will initially slow down, and a decline in production will begin in a few months. It is important to note that over the past ten years, American shale companies, despite an explosive growth in production volumes, have not been able to ensure a positive cash flow from operations, even with average oil prices above $60 for the period. The sector absorbed huge investments valued at about $400 billion, but its financial situation was dire even before prices fell; now for many companies, it is disastrous.

In 2019, a series of bankruptcies of the shale companies took place, and, undoubtedly, this year, against the background of sharply reduced prices, we will see new bankruptcies. On the other hand, the experience of the best American shale producers has shown that they can survive for a long time at low prices due to the concentration on the so-called sweet spots – the most productive areas of deposits, the active use of price hedging and access to cheap financing, and, most importantly, gigantic technological progress in drilling long horizontal wells and multi-stage hydraulic fracturing techniques. Until recently, this allowed for the extension of credit lines so that companies could continue to receive financing. A new factor that has manifested itself literally over the last couple of years is the attitude that oil and gas investments are extremely “toxic”; they are met with accusations that investors are ignoring the problem of global warming, and are therefore deemed socially irresponsible. Many investment funds now restrict or completely prohibit investments in traditional hydrocarbon energy companies. If earlier the bankruptcy of oil shale producers meant that someone else would take their assets on the balance sheet and be able to get new debt financing, now this scenario looks more problematic.

Marc-Antoine Eyl-Mazzega on OPEC During the Oil Crisis
Due to the crisis and economy’s collapse due to coronavirus, OPEC will have an even harder time maintaining discipline than before, suggests Marc-Antoine Eyl-Mazzega, Director of Ifri’s Centre for Energy. When the organization’s members have a fundamental interest to try to pump and sell whatever they can, the smaller producers will refuse to cut the production because, for them, that would be a catastrophe, the expert explains.

Over the next few months, we will witness a “live experiment”, where we observe the next test of the American shale industry for strength. If a scenario where a sufficiently rapid and large-scale (up to 2 million barrels per day) reduction in oil production in the USA is realised, and the coronavirus pandemic recedes by this summer, prices may return to the level of $50-60 dollars per barrel in the wake of the global recovery of economic growth. Russian oil exporters will be able to defend most of their market share, and the Russian government will be able to fulfil its budgetary obligations through the devaluation of the ruble and the use of its NWF reserves.

If, however, the fight against the coronovirus drags on, and the “blitzkrieg” of the Saudis in the oil market fails, then the confrontation between the producers can enter a “trench war” phase. In this case, oil prices will linger for a long time at levels of about $30 per barrel, and losses for all parties can become very significant. A long period of low oil prices will force Saudi Arabia to cut social programmes, which is fraught with the threat of an explosion of discontent in the Kingdom with its young, large, and paternalistic-minded population. It is hard to imagine the worst course of events for the ruling elites, given the likelihood that the throne will pass to the Crown Prince. Another risk for Saudi Arabia is the rapid depletion of gold and foreign exchange reserves, which have already declined markedly since 2014.

At the time of the sharp decline in oil prices at the end of 2015, Russia demonstrated how it will deal with the crisis by means of a large-scale devaluation of the ruble and the use of reserves accumulated in the stabilisation fund, as well as countercyclical public investments and public-private partnership programmes. But a protracted period of low oil prices will undoubtedly negatively affect GDP growth rates, increase unemployment, and a weakening ruble will lead to higher inflation and the impoverishment of the population.

Finally, in the United States, low oil prices, while creating problems for producers, will bring benefits to consumers. Traditionally, low oil prices have been unequivocally regarded as beneficial to the US economy. Now that the country has turned into a net exporter of oil, the situation has changed somewhat. With the decline in oil prices, both American companies and American workers employed in the industry have begun to lose something. But the United States remains the largest consumer of oil and petroleum products in the world, and for the country as a whole, low oil prices will help restore economic growth after the crisis. Also, other large consumers of hydrocarbons, primarily China, will be able to restart economic growth.

The crisis will end sooner or later. According to its results, a large-scale “oil matrix reloading” and the emergence of new winners and losers are expected. And now the next reboot will be associated with the transition to carbon-free technologies in the energy sector, and it is just around the corner. This challenge will require hydrocarbon-dependent countries to scale up their economic models and reform their energy sectors. But that is another story.

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