Demand Takes Brutal Hit
On the demand side, we continue to believe the impact of COVID-19 will not persist throughout the entire year, and that oil demand will recover in the second half of the year. Even so, we have now revised our total oil demand growth for 2020 downto 80,000 b/d. That reflects more than a 325,000 b/d decline in demand for products made from crude oil. Besides fuel oil, jet fuel has the largest decline. Gasoline demand slows to a crawl and total bunker demand shrinks. (See chart below). Thedecline in crude-derived products, however, continues to be more than offset by gains in LPG and ethane demand, which rise by 400,000 b/d. With global economic growth slowing by at least 0.5 percentage points, demand for petrochemical feedstocks has been revised down, with the biggest impact on naphtha. Ethane and LPG use, however, are sustained bythe startup of new ethylene and PDH plants and thus still have scope for growth.
Saudis Douse the Market
The Saudi decision to abandon production restraint and ramp up production significantly is quite striking because it was taken while oil demand is falling precipitously. Every day that this supply surge chases declining demand, the more inventory will accumulate and the longer it will take for prices to recover even if production were to fall. With our current demand forecast and distinctly higher Saudi production, the surplus in the global market will average 2.7 million b/d in the first half of the year.
Will Come to a HaltIf crude prices remain in the $30s for the rest of the year, the impact on non-OPEC production will be substantial. The quickest impact would be felt in U.S. shale which is quite elastic to price. We estimate US shale could end the year about 1.0million b/d lower than current levels.
If prices move back solidly into the $40s that decline would be closer to 350,000 b/d. Other producers would scale back growth, but not necessarily decline. Non-OPEC growth would come to a halt in 2021.
Saudis Have Been Swing Producer
Over the last few years, the Saudis have knit together production restraint agreements with roughly 20 countries. Although these agreements have looked good on paper, the Saudis have carried most of the burden, aided by Kuwait and the UAE.Other OPEC members, such as Iraq, Nigeria, Ecuador, Gabon and Congo have produced above their agreed targets. This has led the Saudis to cut by more than their share. The same is true for the non-OPEC countries. They agreed to cut production by 400,000 b/d in 2019, but ended up cutting by less 100,000 b/d. Then, at the end of 2019, they agreed to cut another 500,000 b/d, but appear to have been at least 200,000 b/d above that target. In short, many countries in the coalition have made promises they have not kept, and the Saudis have covered for them. In the meantime, production from other non-OPEC producers, most notably the U.S., has surged. Last week this arrangement blew up.
Russia has been Symbolic
Russia’s participation in these agreements has been largely symbolic. In 2019, Russia was asked to cut production by less than 3 percent and ended up not cutting at all on an annual average basis. Whereas Saudi Arabia cut by more than 8percent. Before last week’s meeting we expected Russia to voice support for whatever deal emerged but do very little in terms of production restraint. This time around, Russia’s rejection of the Saudi-sponsored agreement in word, as well as deed, was just too much for Saudi Arabia.
Is this Really a War for Market share
The breakdown in talks between Saudi Arabia and Russia has been seen as triggering a market share war. Yet, in many respects the Saudis have already won that war, except perhaps in Europe and China
Do the Saudis really want to take market share from Russia in Europe? Is that the prize? Russia supplies 3 million b/d crude oil to Europe, of which 1.4 million b/d are via pipeline to inland refineries. In the aftermath of last year’s oil contamination and amid friction in Russia’s energy relations with Belarus, alternative suppliers could chip away at Russian market share in these markets. But Europe is not a growth market.
Or is China the prize? Pipeline deliveries and contracted seaborne volumes protect more than half of Russia’s market inChina, so the amount of market share up for grabs is somewhat limited. China, like many other countries wants a diversified group of suppliers, including multiple suppliers from the Arab Gulf. China has also signed a trade deal with the U.S. which will reserve some of their market for U.S. exporters.
Maybe 2.0 million b/d of Russia’s 5.0 million b/d of crude exports could be at risk, but most of that would be in Europe. Given the geography of Russian exports and the reality of weak crude demand we believe Saudi Arabia is targeting Russia’s markets not necessarily to steal that 2.0 million b/d, but rather to get Russia back to the bargaining table.
So is a New Production Cut in the Cards
Is the Kingdom willing to wait 6-12 months for low prices to diminish their competitors? We believe the Saudis could if they absolutely wanted to, but it would be difficult to manage the economic fallout of lower oil prices inside the Kingdom.Moreover, with such weak global demand it will be hard to sell additional crude. Much of their additional crude will end up inventories. It is reasonable to assume the Saudis would prefer to produce 9.8 million b/d at $50 (daily revenue of $490million) than 12.0 million b/d at $30 (daily revenue of $360 million). Indeed, higher prices have been a key requirement ofCrown Prince Mohammed bin Salman as he has funded proxy wars in Syria and Yemen and made efforts to reform the Saudi economy.
Meanwhile, oil producers all over the world, including Russia, will struggle to produce profitably in the next few months as prices remain in the $30s or even go lower in response to rising inventories. They are facing falling demand and price for their product and weak domestic growth due to the coronavirus and lower oil prices. And now a big producer is lifting output substantially and moving inventory on to the sea. A new production agreement seems inevitable. Russia’s participation appears to be a prerequisite for the Saudis, hence the effort to lower prices and target Russia’s customers in Europe and China.
How Much to Cut
Our analysis of the global oil balance depends a bit on how long Saudi Arabia keeps production at very high levels. In order to deliver 12.3 million b/d in April as claimed, the Saudis would have to use most of their spare capacity and draw down inventories. Although the Saudis have said they will raise productive capacity to over 13 million b/d, this will not be immediate. Moreover, global crude demand is weak. As a result, we believe Saudi production will drop back closer to 11.0million b/d level after April. Given demand and slowing non-OPEC supply, it would take a cut of more than 2.0 million b/d as of July and for the remainder of the year to balance the market. If Libya’s production were to remain offline for the rest of the year, the cut could theoretically be smaller.
In the summer of 2013, we pointed out that either Saudi Arabia or the U.S. would end up as swing producer. In 2015 and2016, the U.S. was forced into that role by high Saudi output and low prices. Since the end of 2018, it has been the Saudis who have cut production and shored up crude oil prices, allowing U.S. production to rise significantly.(see chart at end).What is happening today could be the leading edge of a change in Saudi policy, signaling a permanent end to their swing producer role. The Saudis recognize that oil demand is heading for a plateau and decline in the next decade or so, and they may want to be sure they are the last producer standing as demand declines. One way to do that is to grow their market and keep prices low to weed out other producers. Along the way, low prices may stimulate demand and push the eventual decline in demand a little further into the future.But today is an unusual moment in time. COVID-19 has crushed oil demand and is threatening economic growth all over the world. Furthermore, the Saudi economy and the ambitions of the Saudi Crown Prince depend on higher oil prices. So, at this juncture, Saudi policy is still likely to be the defense of price, but with the full support of other producers. That would mean today’s market is a gamble to bring everyone back to the table. Unless Russia really digs in its heels, we expect a new production agreement in the months ahead.
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