Deal is Done; Prices Will Recover, but Under the Weight of Stocks

Countries Agree to Massive Supply Cut

The 20 Countries of OPEC+ have agreed to an historic production cut to address the demand destruction of COVID-19. They have pledged to cut production by 9.7 million b/d from an October 2018 base, except in the case of Saudi Arabia and Russia who will cut from 11.0 million b/d.

This agreement is a significant victory for Saudi Arabia. The Saudis will cut production in May by close to 4.0 million b/d from April’s levels. This is a dramatic reduction. But, in return we estimate Russia, who refused to cut production in early March, has already lost production and will cut by roughly 2.0 million b/d between end March and end June. Meanwhile Iraq has pledged to cut almost 1.1 million b/d. This is another notable victory for Saudi Arabia because Iraq has done very little in recent years in support of production restraint. Most of the other contributions to this epic agreement were close to our expectations. Except Mexico, where the cut will be only 100,000 b/d after being asked to cut by 400,000 b/d.  

A key wrinkle in the agreement is that the production cut is only for two months: May and June. After that, they will scale back their restraint to roughly 7.7 million b/d (from the October 2018 base) for the rest of the year. There is a subsequent agreement for 2021 and early 2022, but we will address that later. Please see accompanying Excel file with current production, the new targets for production and where we believe each country will end up in terms of compliance.

As expected by ESAI Energy, the countries at the G20 meeting were only cautiously supportive of the OPEC+ agreement. Outside that forum, however, several countries have referenced current or expected declines in their production. The U.S. government has suggested U.S. producers will cut production by 2.0 million b/d by the end of the year. We have closer to 1.7 million b/d, but from April levels. Meanwhile Canadian production is falling, and, in December, we project it to be 1.4 million b/d lower than February levels. Brazil has now stretched their expected reduction to 300,000 b/d. Others will cut production in response to lack of demand and low oil prices.

What Does this Mean for the Market?

Our view on the impact of this remarkable multilateral reduction in oil supply has not really changed from the Market Alert we sent out last week: Market Alert: Historic Production Cut in Sight.

As the left-hand chart below shows, even with lower production, even weaker oil demand (we currently have demand down 8.8 million b/d this year, but it is a moving target) will keep supply above demand through June, and basically balanced in July. After July, demand will exceed supply.

As the right hand chart below shows, the massive stock build underway will essentially stop in July and begin to reverse in August. The excess inventories building this year will fall from a peak of about 1.6 billion barrels to a level under 700 million barrels.

Prices Will recover

If all of these supply pledges come true or close, and if the social distancing and other measures associated with COVID-19 are eased or lifted, then oil demand will recover in the face of lower supply. The global market will tighten, and prices will rise.  There are several uncertainties in terms of market perceptions, however, that will temper the price recovery. The first is the inventory overhang which will keep spot prices in the physical markets below futures for several more weeks, and thus attenuate the impact of recovering prices. The second is the possibility that as prices rise late in the year, some of the production restraint in non-OPEC countries will diminish. The third is the depth and duration of demand destruction this year. Even so, looking out from today, we see Brent back into the $40s late in the second half of the year.

SPR Fill

The success of the OPEC+ agreement was somewhat dependent on the active participation of President Trump. Although he could not pledge production cuts by the U.S. private oil industry, he indicated production would fall significantly, and essentially took the objections of Mexico to cutting production off the table. The next market-shaping action the Trump Administration is likely to take is a deal with Democrats in Congress in the Phase 4 stimulus to appropriate $2-$3 billion to purchase 65-75 million barrels of crude from U.S. producers to put in the SPR. This government stocking is a form of demand that would support prices as well.

Click here to request a copy of the accompanying dataset, "OPEC+ Production Cut".

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