Figure 1- Brent Crude prices in $ per barrel over lats 5 years
In late 2015, the oil prices crashed after the US hiked Fed rates for the first time in 10 years. The second big fall came in late 2018 after the US decided to go easy on sanctions on Iran leading to expectations of a supply glut. The recent fall has been the quickest and the most violent. Oil prices have fallen from $70/bbl to $31/bbl in a span of just 2 months. The big fall came on March 06, 2020 after the oil supply deal between OPEC and Russia fell through.
Why did the OPEC talks fail?
When OPEC and Russia met in Vienna over the weekend, the big item on the agenda was deeper cuts in daily output. Currently, OPEC and Russia are jointly cutting about 2.1 million barrels per day (bpd). OPEC had proposed an additional cut of 1.5 million bpd of oil to stabilize prices. This would have taken the total supply cut to 3.6 million bpd. While Saudi Arabia was a strong proponent of additional cuts, Russia had its own doubts.
Russia believed that the supply cut would have supported crude prices but the US shale industry would have got a lifeline. In the past, the US Shale industry had managed to survive because of easy loans from the banks. However, the slowdown would have made it difficult for shale companies to get funding. Also, the fall in junk bond prices led to higher yields. Russia wanted to push the US to a corner with lower oil prices.
Is the Saudi gamble on supply and price worth it?
On March 06th oil prices crashed by 30% after Saudi decided to push supplies beyond 10 million bpd. At the same time, it cut the prices of crude by $6 to $8 per barrel. This is the sharpest cut in prices and clearly intended to push the US and Russia to a corner considering that they have a much higher break-even level. $35/bbl is a price at which neither the US nor Russia can sustain for too long. Saudi Arabia also realized that the current level of supply cut at 2.1 million bpd was insufficient considering the mega plans of the US to expand supply by the end of this year. If you add the 20% demand compression in China post the Coronavirus, Saudi Arabia’s options were discrete; go all out with an additional 1.5 million bpd cut or go for an all-out price war.
Russia wants to push the US to a corner
Clearly, Russia wanted to push the US to a corner. A supply cut would have pushed oil prices higher and given a lifeline to the US shale companies. Despite the US becoming the swing producer, US shale companies are hardly making profits. For Russia it was an opportunity to squeeze the US shale industry with lower prices. That has anyways been achieved. Russia also realizes that low oil prices would create larger problems in the oil-rich states of Texas and North Dakota; both of which have been loyal to Trump. Putin is betting that US banks are not going to be willing to bankroll shale any longer if global prices are so low.
Why the US yield curve and Prince Salman will drive prices?
Despite the focus on the US and Russia, the real driver of oil prices will continue to be Chinese demand. The US yield curve is clearly pointing at an economic slowdown. A partially inverted yield curve with 30-year yields below 1% for the first time; clearly hints that the largest economies in the world are expected to show down. Chinese virus was only a trigger.
Prince Salman has shown a propensity for taking big risks and the decision to flood the oil market is one such risk. However, Saudi Arabia has adequate spare capacity and can quickly ramp up production by 1 million bpd. Due to massive reserves, the export push can start right away. That will keep oil under pressure in the short term. But the bigger problem is that oil consumption in 2020 is expected to contract for the first time since 2008. A 2% fall in demand, as projected by the IEA, could keep oil prices low for the rest of the year.
The Chinese virus may have just about triggered a price war in oil. In any price war, nobody comes out richer. It will now be a case of who blinks first. But that will hardly be an issue till the time Chinese oil demand remains weak.