US oil sinks - beginning of the end for crude?

25/04/2020

This week marked the first time in history that US oil (WTI crude) moved into negative pricing. The pricing of a futures contract for May is in itself not overly telling. Yet global analysts are quietly trying to understand if this is a technical one-off event due to over-supply in the market and demand falling off a cliff as a result of COVID-19 (-14m boe p/d), or the beginning of the end for big oil. Brent oil pricing, the world’s crude benchmark, is hovering just above $20 a barrel. $100 oil hasn’t been seen for five years - nor will it ever again. These events are problematic for the Organisation of the Petroleum Exporting Countries (OPEC) cartel comprised of the world’s largest traditional oil producers, as they are for President Trump who recently crowed of the importance of a ‘historic deal’ he brokered with OPEC to cut production. Global storage capacity (6.8 bn barrels) is filling up fast and is expected to be tested within the next 3-4 weeks.

This momentous drop in the oil price is as much a problem for the big producers as it is for the smaller minnow nations. Saudi Arabia, the world’s largest producer (12.5 million barrels per day) is widely believed to require a sale price of $80 to break even. Their recent ramping up of production was an open display of their ability to open the taps and retain market share. This is highly problematic however for smaller producing nations that wholly require oil receipts to fund their economies. As the international community becomes ever more occupied with global challenges like COVID-19 and climate change, what is to stop a host of countries that literally cant fund public services or turn on the lights moving ever closer to social disorder.

Many OPEC countries, much like the rest of the world, will be keenly watching events in the US in the run-up to the November general election. For many of them, Trump has been a blessing given his laissez-faire approach to various aspects of their domestic and foreign policy, and dogged determination to keep the oil price high. Trump represents for them an extension of the current world order. They will not be cheering on Joe Biden. Yet Trump’s attention and interests are not aligned with his partners in the Middle East. Given his performances in the press briefing room this week, he is focussed on two issues – spinning public perception on the US federal government’s response to the Coronavirus, and re-election. What Middle East partners, Russia, or China for that matter do in their near-neighbourhood wouldn’t make it onto page two of his watch list. 

The Institute of Economic Affairs (IEA) expects oil demand to bottom out now and pick up again towards the end of May, returning to demand levels seen at the beginning of the year by November. Despite movements like Extinction Rebellion and a global consciousness to move away from fossil fuels, oil is here for the foreseeable, yet will be prone to incredible price volatility and over-supply. Why? Many major producing nations have simply not diversified their economies sufficiently to move away from the black stuff. This latest set of developments, however, are likely to drive a major market restructuring. All unprofitable and costly producers will either adapt or die. It is estimated that anywhere between 25-30% of producers will go bust in the next 12 months. The current Coronavirus lockdown, however, isn’t indefinite. Some semblance of normality will ultimately be restored. Middle East and Gulf oil is probably the cheapest oil to extract and thus will always be ‘the last man standing.’

Global actors like Russia and China will see opportunity, not just in the oil market, but through ‘investments’ in other countries of strategic interest, while replenishing strategic stocks at rock bottom prices. Both Russia and Saudi Arabia have in effect achieved their desired goal of crushing the shale industry by pricing it out of the market, yet have hurt themselves economically in the process.

Trump’s foreign policy outside of trade has been predominantly focussed on containing Iran. In this context, Iraq recently unlocked its 5th oil and gas licensing round in an effort to signal its intent to wean itself off Iranian supply. Despite commercial opportunities, international oil corporations and the US specifically will be less attracted to these sorts of markets due to increased risk, lower profits and a previously buoyant US shale industry. Additionally, the Texas State oil and gas regulator met this week to discuss output limits on State producers, with Trump coming under increasing pressure to boost prices to stave off US industry job losses.

Producers that do not have cash reserves will, of course, suffer and may experience social unrest if they are not able to keep their end of the social contract. While Middle East oil will slowly become less and less relevant for the US, it does, however, rely on the region to continue paying for its defence in terms of the larger geopolitical game. This capability may be impacted by fast emptying coffers. GCC economies may be battered in the short term, but they possess sufficient reserves and stable enough societies to ride out the storm. How long they take to recover and prosper however is another matter.

It is too early to tell definitively what this all means, especially given demand for oil will return as economies and countries emerge from lockdown. What is true however is that oil is no longer the only game in town. Austria and Sweden have in the past week closed their last ever coal plants. The COP agenda will return. The International Renewable Energy Agency recently released a report claiming that investment into renewable energy would result in the delivery of global GDP gains of around $98tn. As the rest of the world looks to renewables and the energy transition, countries that have but one commodity source, oil, may see the sun setting faster than they think.