Oil Market Commentary
What’s Going on in Oil Markets?
It’s not just all about Saudi Arabia vs. Russia
by Sanjay Khindri, CFA on April 7, 2020
The global oil markets have been riled by the Covid-19 pandemic, which has caused a significant contraction in global oil demand due to the near-halting of economic activity. The supply-demand imbalance has also been aggravated by an increase in OPEC+ production (OPEC plus Russia). This increase in production was the result of a temporary collapse in the OPEC+ alliance. For the time being, OPEC+ has not agreed on any supply curtailments to help balance markets, and OPEC+ members have been free to produce as much as they desire. This could change very soon, but we think significant OPEC+ cuts are unlikely without a global coordinated response, including participation by the U.S.
Estimates of the current decline in oil consumption are fairly dramatic, ranging anywhere from 20% to 50%. This amounts to 20 million barrels per day (MMBbl/d) to 50 MMBbl/d in short-term oversupply. Assuming the economy begins to reopen in a couple of months, the full-year 2020 impact on demand could average anywhere from 5 MMBbl/d to 15 MMBbl/d, depending on the magnitude of the rebound in global GDP.
We make two important observations:
1) The short-term and full-year oversupply situation cannot be solved solely by a select group of countries cutting production.
2) Regardless of what OPEC+ eventually agrees to, production from the rest of the world, including the U.S., will have to decline significantly over the next 12 months.
The news headlines have centered on a “spat” between Saudi Arabia and Russia as contributing to the record crude price collapse, and how this spat is unfairly hurting U.S. producers. The reality is a bit more nuanced. First, a bit of historical context.
In 2014 and 2015, record oil supply from the U.S. overwhelmed the global market. At that time, OPEC decided not to reduce its own supply in order to protect its market share from an over-leveraged U.S. energy sector. The result was a dramatic drop in global oil prices and a reset of U.S. oil production. Beginning in 2017, OPEC began to cut its production to help fully bring markets back into balance. Since then, OPEC+ has been very supportive of the supply-demand balance, allowing U.S. oil production to outpace global demand growth by an average of 320 thousand barrels per day. (see chart below):
Source: Gallatin Capital Management
We believe the reason the OPEC+ alliance has temporarily fallen apart is less about attempting to reign-back-in U.S. oil production, and more about the high level of uncertainty regarding oil demand.
The balancing mechanism that OPEC+ implicitly employs consists of analyzing the oil price response relative to a change in OPEC+ output (i.e. a revenue maximization exercise). Under normal circumstances, this trade-off can be calculated with a certain level of confidence. In early 2017, U.S. oil production growth had slowed while demand was stable, giving OPEC visibility into the inventory effect of a cut in its own production. Today, there is zero visibility: even a massive cut in OPEC+ production might not be enough, implying that OPEC+ would be disproportionately cutting production while prices continued to fall; a very poor strategic outcome.
A worldwide producer response is the only solution to this particular supply-demand imbalance: no one country or small group of countries alone would rationally attempt to balance the market with this much demand uncertainty and this much oil oversupply. Without a broad coalition of the largest producers in the world cutting production (including the U.S.), the best we can hope for is a rollback of OPEC+ production increases, primarily from Saudi Arabia and the UAE (~ 3 MMBbl/d). The table below highlight the world’s largest oil producer countries and the cuts in production required in order to take 16 MMBbl/d out of the market for the full year 2020.
A cut of 10 MMBbl/d solely by OPEC+ would imply a 21% production cut by the alliance, without guaranteeing that oil storage wouldn’t hit its limits: therefore, no assurance that it would even help prices near-term. If other countries came on board and cut their production by 21%, the oil surplus could be reduced by a much more meaningful 16 MMBbl/d.
Source: Gallatin Capital Management
Is a global coordinated response even possible? Short answer, probably not.
Energy producers outside of OPEC+ are generally private companies, making it difficult to directly control production levels. That being said, some U.S. energy companies and members of the Texas Railroad Commission (regulator of Texas oil and gas production) have advocated some type of coordination.
This leaves us with the most likely outcome for the time being: the market will take care of itself. U.S. production growth will have to moderate and then decline very quickly; OPEC+ will end-up reversing its recent production increases; depending on demand levels, storage may fill, and oil producers may need to shut-in wells.
The benefit of a coordinate response is: 1) to prevent storage from filling and oil prices temporarily dropping to single-digit levels and 2) to maintain lower production levels for a sustained period of time in order to expedite inventory normalization.
OPEC+ will meet later this week, and we would be surprised if they alone announced a significant reduction in production. If they do, it implies that they have some faith and visibility that global oil production outside of OPEC+ will be declining dramatically in the near future. Therefore, OPEC+ production cuts would simply be tagging along to a global production response driven purely by free market forces.
A Note on Oil Tariffs:
There is a reason why the U.S. still imports over 6 MMBbl/d of oil (29% of our demand) even when we produce more oil than we consume: Some U.S. refineries have been built to only process certain grades of crude oil that can only be imported. Implementing tariffs would only harm the U.S. refinery industry while not creating any new demand for U.S. shale oil. In fact, it would increase the risk of retaliatory tariffs for other products that the U.S. exports: refined products, natural gas and natural gas liquids.
Gallatin Capital Management, LLC
Important Disclaimer: This material is for your information only and is not intended to be redistributed or used by anyone other than you. The information contained herein should not be regarded as an offer to sell or a solicitation of an offer to buy any financial products. This material, including any investment recommendations herein, is intended only to facilitate discussions with Gallatin Capital Management as to its investment offerings and strategies. The given material is subject to change and is not guaranteed as to accuracy or completeness and it should not be relied upon as such. The material is not intended to be used as a general guide to investing, or as a source of any specific recommendations.