By: Roger Diwan, vice president, financial services, IHS Markit
A crash of historic proportions. Saudi Arabia’s answer to the breakdown of the Vienna Alliance on Friday was swift, making it known that it is preparing to hike output to as high as 12 MMb/d in the months ahead if it finds takers for its discounted barrels. The signal given by Saudi Aramco on Saturday, when it slashed its official selling prices (OSPs) across the world to unseen lows is the mechanism to unleash the supply flood, starting in April. Oil markets are now facing an unprecedented double shock; a demand crisis and price/market share war that will likely push crude prices to multi-decade lows. Brent prices are already down $15/bbl (-30%) since Thursday and stood just above $35/bbl at the market open in Asia. Prices are now at the mercy of global fundamentals, the severity of the looming surplus and the price structure required to unlock demand for storage or incremental refining purchasing.
In the short term, this likely means prices revisiting the 2016 and 2008 lows, with all the pain it entails for the sector. An eventual path to recovery now looks even more treacherous than it did a week ago. Not only does demand have to rebound from the Coronavirus shock, but it will also now depend on the course of the price war and the stamina of Saudi Arabia and its OPEC partners in the face of collapsing revenues. The likelihood of that recovery happening in the second quarter is low. Now, we are waiting to see the size of the stockbuild the industry will have to absorb and then manage for the rest of 2020 and potentially beyond.
From ultimatum to price war. At the meetings in Vienna on Thursday and Friday, Russia again refused OPEC’s 1.5 MMb/d joint incremental cut proposal, a proposal led by Saudi Arabia. Without any counter proposal or willingness to extend the present cuts, Russia simply walked away and to the surprise of all announced a lifting of all production constraints on Russian producers effective 1 April. Saudi Arabia, without any plan B to manage the fallout within OPEC, decided that it would also adopt the same position and weaponized its Official Selling Prices (OSPs) on Saturday. This unceremonious end of the Vienna Alliance was a reflection of the gap that has long existed between both countries’ strategy, but also by the failure of diplomacy over the last few months.
Slash and burn. Aramco’s OSPs are fixed monthly differentials to their respective regional crude benchmarks. The proposed differentials for April were staggering, with OSPs slashed between $5/bbl and $8/bbl in the largest month-on-month revision in recent memory. Cuts went across the board but were particularly acute in the Atlantic Basin, with OSPs to Europe and the U.S. slashed $7/bbl or more, clearly aimed at key Russian markets. Price changes were followed by Saudi officials letting it be known that a surge in production from the Kingdom is underway, which would underpin the discounted pricing strategy. Markets are now facing a supply battle amid a demand crisis. The last time this occurred was in 1998 during the Asian financial crisis, when Venezuela’s aggressive production growth triggered a price war and pushed oil prices into the single digits.
It’s not “if” stocks will build significantly, it’s by how much. Markets are now facing a severely oversupplied market in 2Q2020 with two uncertain dimensions, the trajectory of demand and the extent to which Saudi Arabia and its Gulf partners are willing to flood markets and allow for very large stockbuilds. Markets face a 1-2 MMb/d potential downside swing in demand (depending on the severity of COVID-19) and 1-2 MMb/d potential upside swing on supply. This represents an enormous confidence interval, and the difference between catastrophically oversupplied (4-6 quarters to unwind) and manageably oversupplied (1-2 quarters to unwind). It’s too early to tell which way balances are trending but the next two weeks will likely provide significant input into that trajectory. In the meantime, very few courageous souls will be willing to hold long positions.
Demand crisis of uncertain (but sizeable) proportions provides the worst possible backdrop for a price war. This supply stand-off is unfolding in the face of what is likely the worst 6-month demand crisis in volume terms in the history of the oil market. Moreover, there remains significant uncertainty around the extent of the demand damage to come. The aggressive containment measures adopted by the Italian government in the Northern provinces over the weekend are a taste of what could still come should the rate of contagion accelerate across Europe and North America (as appears likely). As things stand, global demand appears likely to contract materially y-o-y for the second quarter in a row, with the main question remaining whether it is a 0.5-1 MMb/d drop or a 2+ MMb/d drop.
Once more unto the breach: Russia, Saudi Arabia and U.S. shale enter low-cost producer deathmatch. Gloves are now off and while Russia and Saudi Arabia’s strategic misalignment was the trigger for this next supply shakeout, U.S. E&Ps will very much be at the receiving end of the price collapse. With WTI prices already trading around $30/bbl in early trading on Monday, the industry will need to react swiftly and decisively in the face of the acute decline in cash flow. The shift to sizeable sequential declines will not be instantaneous, but at these prices are likely to come by the third quarter will be severe through the end of 2020 and 2021. It will also be bruising for Saudi Arabia and Russia, who will see plummeting government revenues. Saudi Arabia’s aspiration appears to be that the supply damage wrought in the U.S. and pain caused elsewhere will be sufficient to bring other producers back to the negotiating table in short order.