The Elements Unfold: A Possible Bottom to Oil Prices

The process of going into lockdown due to the coronavirus pandemic has been revealing, especially in regards to oil. There are many elements to the smooth operation of global oil logistics that are now facing potential problems due to the unprecedented lockdowns. Here are a few of these elements and the complications the lockdown process is exposing.  

Oil geography: The world’s oil producers are not necessarily located close to the largest centers of oil consumption. That means foreign oil shipping transit times are long, often thirty to fifty days between major production regions and some of the largest consumer economies. Now, as uncertainty regarding the length of lockdown restrictions mounts, it is harder for refiners in these large economies to anticipate local demand thirty to fifty days in advance, making it more difficult to know how much imported oil is going to be needed. Given this new challenge, storage plays an even more crucial role in balancing fluctuating supply and demand in the oil market, but rapidly filling tanks and ships are limiting room for error. As a result, oil in storage has rapidly approached its physical maximum capacity. The strong link between changes in the level of economic activity and rate of oil use reinforces the significance of the pace and success of reopening local economies to the trajectory of oil demand. Uncertainty about the latter is now hindering operational efficiency of oil exporting countries and refiners alike.  

The inventory conundrum: For now, the problem remains too much oil. Even with economic activity returning in Asia, the incredible surplus of oil inventory that is currently being amassed is so large, it will take months, if not years, to work off. Some forecasters, like Cornerstone Macro, suggest 2020 could end with over a billion barrels stuffed in ships and storage tanks around the world. Back at the end of 2015, OPEC thought 593 million barrels was going to be a formidable burden on oil prices, even in the context of a growing global economy; twice that level in the face of a now declining global economy could keep oil prices low for the foreseeable future. Gulf oil producers Saudi Arabia, Kuwait, and the United Arab Emirates appear to understand the magnitude of the supply problem. They announced this week new additional “voluntary” cuts in June of a supplemental 1.18 million barrels a day (b/d), on top of cuts that began May 1, 2020, presumably to make additional room for an easing of inventory levels as the third quarter approaches. 

Oil’s boom and bust price cycle: Several Wall Street firms are already suggesting that the oil market has seen its lows.  That thinking is based on the idea that oil demand is slowly recovering in a patchwork of economic re-openings and is combining with the start of oil supply reductions – both voluntary and involuntary.  Goldman Sachs, for example, is predicting a recovery in oil prices in 2021.  

Oil has been cyclical for many decades. There is even a Texas platitude about it: “the solution to low prices is low prices” (or to high prices, high prices). The implication is that if oil prices drop too low, companies go bust and governments fear a fall from power. Eventually, low prices or geopolitical events, or both, disrupt supplies, paving the way for prices to rise back up. Texans are reluctant to use the phrase right now, but I’d be willing to bet, they are thinking it. 

In fact, there is evidence that low prices are already doing their usual trick of curbing oil supply in several locations around the world. For example, North Dakota has reported that its oil output from shale is down 450,000 b/d as a total of 7,000 wells were throttled back. Texas pipeline operator Plains All American Pipeline suggested recently that there is a 1 million b/d drop taking place this month in the high producing Permian Basin Shale. Citi expects U.S. stripper well production, that is, small wells that produce under 5,000 b/d, to decline by an additional 450,000 b/d by year end, if prices do not recover. Storage constraints have also forced about 300,000 b/d of oil production in Alaska to be temporarily closed down this month. Investment firm Goehring & Rozencwajg say closure of U.S. stripper wells and other marginal fields could shave 1.5 million b/d off U.S. oil output permanently by the end of the year. They project that U.S. offshore fields may also be shuttered by about 500,000 b/d. They add that cuts to capital spending in the United States and elsewhere will mean new production is unlikely to offset natural geological declines in output in aging oil fields, rendering $20 oil as unsustainable. 

Beyond immediate field closures, the current collapse in capital expenditures for future drilling could lay the groundwork for a new upward oil price shock in the next few years. Reductions in capital spending by major oil companies this year could translate into lower production several years down the road as the delay in new projects now results in less new production going forward. This could set the stage for an oil price rebound after 2022, depending on global oil demand trends. BP announced this week that it will be reducing the number of wells drilled in Iraq’s major Rumaila field by more than half. Royal Dutch Shell has delayed its major Whale oil field development in the U.S. Gulf of Mexico. Russian oil companies are throttling back their least efficient wells to comply with the new oil producer OPEC+ agreement, with some risk that certain wells might face a permanent loss of production from possible damage to equipment or reservoir pressure. Russian state flagship firm Rosneft has said it might have to cut its capital expenditures by up to 30 percent this year. Low oil prices could also mean other national oil companies in Africa and Latin America will have less capital available to spend on domestic oil production capacity. Already, budgetary constraints have contributed to a decline in oil production in recent years in Mexico and Venezuela. 

Structural changes to demand: The speed and magnitude of the loss of oil demand, the buildup in storage, and the shut-in of oil production around the world is unprecedented. And, it also coincides with a coming wave of digital energy technology that could reduce oil use in the next decade or two. That raises the possibility that low prices won’t be the solution to low prices. Even in the shorter run, the pandemic is also leading to instantaneous changes in behavior, like telecommuting, that might be stickier than expected. The drop off in the volume of global trade is also curbing oil use. Bernard Looney the new CEO of BP suggested in a recent interview that the pandemic was “adding to the challenges of oil in the years ahead.” 

Geopolitics and quid pro quos:  A key disciplinary mechanism to ensure that oil producers honor cutback agreements within Organization of Petroleum Exporting Countries (OPEC) is the threat of an oil price war. Now, with global oil storage brimmingly full, producers must find other ways to ensure parties to agreements to stabilize oil markets meet their obligations. Oil consumer and producer relations are often modulated by self-understood, but rarely explicitly mentioned quid pro quos. As nations come under unprecedented economic and political strains in light of the pandemic, important bilateral relationships that underpinned oil market stability are now realigning. This realignment is creating new geopolitical uncertainties at a time when stronger bilateral and multilateral relations are required. The possibility for progress on frozen conflicts exists but is by no means assured. If anything, a worsening situation for fragile oil states poses additional risks. Historical studies show that intrastate conflict in oil producing countries leads to oil supply disruptions in about half of the cases of such unrest.   

Ironically, even with the burgeoning surplus of oil in the market, there is still anxiety that low oil prices could contribute to further instability in war-torn regions, potentially ushering in a new phase that would restore a geopolitical premium in oil prices and possibly create a new cyclical upturn. Indeed, oil prices rallied briefly last week after news reports that the United States was moving some of its military assets in the Middle East. The fact that markets reacted to a relatively small change in U.S. troop and missile repositioning indicates that even with large oil inventory surpluses, markets are not immune to the kinds of geopolitical risks that could emanate from any renewed conflict in Iraq or other simmering regional hotspots. The United States continues to engage diplomatically in the Middle East, and wants to find a solution that would improve humanitarian conditions in Venezuela. Russian flagship national oil company Rosneft has ceased trading in Venezuela’s oil, possibly creating a diplomatic opening between the United States and Russia on that and other matters. Indeed, the success of the OPEC+, G-20 coordinated efforts to stabilize oil markets could potentially lay the groundwork for the resolution of a number of frozen conflicts. 

Yet, despite diplomatic progress on several fronts, a realignment of relations among some of the world’s largest oil producers is in an early stage and could easily be derailed. Facts on the ground in Venezuela are complicated by China’s role and Iran’s new involvement providing fuel and technical aid to Venezuelan strongman Nicolas Maduro. Iran’s Revolutionary Guard has also launched its first military satellite adding to stresses already existing in light of Iran’s military support of regional proxies in Yemen, Iraq, and Lebanon. The Iranian moves come as President Donald J. Trump publicly instructed the U.S. Navy to “shoot down and destroy” any Iranian gunboats that make harassing approaches to American vessels, leaving oil markets with the realization that geopolitical risk has not completely disappeared, even as governments have focused on the pressing problems of the pandemic, oil market stability, and national economic crises. 

Conclusion: Oil producers, consumers, and governments have found themselves in a new and uncertain situation caused by the COVID-19 pandemic. Oil will remain on the G-20 agenda as countries cope with unexpected logistical and geopolitical issues surrounding oil trade and finance. Suggestions that a new global architecture could emerge supporting ongoing multi-national dialogue and coordination between major producing and consuming countries to the benefit of all are productive but likely too optimistic. With so many new and variegated concerns to juggle, the prospects of continued joint action will be challenging.