By Amad Shaikh
Last week was the calmest yet in the weeks following COVID-19 and price-war related events that have rocked the oil complex. Normal standard deviation in Brent in w-o-w is about 3%, and the last w-o-w saw 3% once again. But… there’s a catch.
Consider what this calm took in stride: announcements of new supply cuts in millions of bpd. In normal times, even a one million bpd increase or decrease can translate into a double-digit price change, but these days, talk of millions of barrels on both supply and demand sides are just thrown around in routine banter.
This last week OPEC+ announced extra cuts of over 1 mbpd between Saudi, UAE and Kuwait, which will result in Saudi Arabia’s production falling to 7.5 mbpd in June, down almost 5 mpbd from its April high. Lower oil exports combined with historically low prices are wreaking great financial stress on the Kingdom, leading to ‘tough’ austerity measures such as tripling VAT and reducing government benefits—measures that will likely constrain future economic growth. Sensing that medium sour grades will be in tighter supply, Saudi Arabia increased their June crude OSPs, opposite to market expectations – forcing buyers to scramble for spot cargoes, and refiners to revisit their economics (perhaps leading to lower runs).
Norway raised its hand to contribute 250 kbpd and majors in USA/Canada oil joined in with nearly 10% announced cuts, with the USA Energy department expecting US production to drop by 2- 3 mbpd by year-end. John Nash would be proud to witness yet another game theory in progress—rational players moving towards a new equilibrium where both parties compromise to accept less of what each wants, but higher payouts than if both do what each wants.
So what was the reaction in crude prices to these OPEC++ cuts? A collective yawn. Regardless of how much supply is cut, demand destruction remains one step ahead, with the EIA announcing a forecast of an 8 mbpd contraction in 2020.
This leads one to wonder whether supply cuts are really bullish indicators, or do they reveal how bad suppliers think the virus demand destruction will continue to be.
On the demand side, easing of lockdowns would certainly help oil demand, but the same government action could lead to higher infections, which could once again lead to more stringent lockdown measures. Last weekend, this fear became reality with 34 new cases popping up in South Korea (highest since April 9) and 17 new cases in the brightest demand spot of China (highest since April 28). Malaysia and Kuwait extended lockdowns. The battle between oil and COVID-19 will continue to a large extent for months to come, until a vaccine or cure is identified. And Dr. Fauci’s warning to the United States Congress of ‘real risk’ of outbreak if states reopen too soon isn’t great news for oil markets.
Nevertheless, cautious optimism is being reflected in the markets with lower differentials between future and physical prices, and contraction of the super-contango tumor. However, even a shrunk tumor could easily resurge under the right conditions, and in the oil market this means supply-demand must re-balance.
Longer-term, when the virus will be a page in history, and when demand returns albeit in more of an L-shape (as analysts are predicting), oil supply may struggle to catch up. As amusing as the specter of oil supply tightness sounds right now, the complex has been historically prone to cyclical responses. For one thing, oil wells can’t be switched on like light buttons. the cost of restarting a well can be significant, and financing options for drillers are very limited. Moreover, Rystad Energy sees lowest oil project sanctioning activity since the 1950s at 33% of 2019 levels. Today’s troubled oil markets could be the beginning of a new price cycle. The oil industry must learn that both patience and cooperation are virtues, and that opportunism in response to price spikes may crash prices once again.