OPEC Plus’ Zero-Sum Oil Game

Prior to the U.S. invasion of Iraq in 2003, international sanctions had severely curtailed Iraq’s oil industry. Oil production sat at 1.4 million barrels a day (b/d). Iraq’s beleaguered refining industry was forced to inject surplus heavy fuel oil into oil reservoirs because there was nowhere else to put it. Iraq’s oil industry was debilitated from years of war and sanctions. It took the country billions of dollars of foreign direct investment and over twelve years to restore production to its pre-revolution 1979 capacity of above 4 million b/d. The breakup of the former Soviet Union tells a similar story. Russian oil production declined slowly from 11.3 million b/d in 1989 to a low of 6 million b/d in 1996. It only reached its pre-collapse level of 11.3 million b/d again in 2018. These lessons from history are important because they demonstrate the severe and long-reaching consequences that can result from mismanagement of oil sectors amidst turmoil created by endogenous or exogenous forces. The COVID-19 pandemic has already shown it could produce unprecedented shocks both from the health crises within petrostates and from external forces such as the sudden loss of demand for oil and the accompanying logistical and operational problems arising from oil pricing volatility.    

The news that the Organization of Petroleum Exporting Countries (OPEC) plus other key oil producers like Russia had reached a historic agreement on April 12, 2020, to jointly cut production by 9.7 million b/d and that other output reductions would follow from other countries such as Brazil, Norway, and Canada was hailed as a good first step to stemming the tide of a massive surplus of oil that is accumulating across the world. The intervention was welcomed by the G-20 and in particular, the United States, which put its diplomatic weight into the effort to broker the arrangement, hoping to stave off a sovereign credit crisis in fragile petrostates and ease the pressure of mounting global oil inventory surpluses. But just a week later, the difficulties of the arrangement, which does not officially start until May 1, 2020, are starting to emerge. OPEC’s own internal calculations anticipate 300 million barrels accumulated in global inventory in March, with even more to come in April. Energy Intelligence Group reported that surplus floating crude oil storage, which is surplus too, and does not include crude oil in transit at sea to meet anticipated demand, had already increased to 117 million barrels by the end of February, up from 99 million barrels at the end of 2019.  

The Wall Street Journal reported late last week that twenty large oil tankers holding a combined 40 million barrels of Saudi crude oil is heading towards oil ports in Texas and Louisiana and are due to arrive in May. Some of the oil was diverted from China, whose shutdown in February left it unable to absorb Saudi oil. But Saudi Arabia also emptied oil from its oil storage facilities in Egypt, Europe, and elsewhere as it was ramping up its declared price war in early March 2020. Now, Saudi Arabia will have to consider if it should slow steam its tankers, that is, have them sail at a slower than normal rate, or even reverse course, to ease the pressure of the arrival of so much oil amidst a continued collapse in U.S. oil demand in the wake of longer than expected economic slowdowns from COVID-19 related directives to shelter in place.  

Saudi Arabia owns a 600,000 b/d refinery in Port Arthur, Texas but overall U.S. refining utilization has fallen below 70 percent of capacity nationwide this month in the wake of collapsing demand for gasoline and jet fuel. It is technically difficult for refineries to operate below 60 percent of capacity without turning off some processing units.  

The time lag between when oil demand began to crater in February and the point at which the May OPEC Plus oil deal will kick in has created a rush to find storage where it might be available. Over 19 million barrels of crude oil was added to U.S. inventories last week alone. American pipeline companies are requiring companies seeking space on their lines to provide proof of destination certificates verifying there is a refiner at the other end of the pipeline willing to take the oil. U.S. crude oil exports are still moving into ships at the same rates as earlier this year with expectations that firm buyers are still there at the other end. Already, as storage tanks and distribution systems fill, logistical problems and related oil price volatility is worsening. Today, for example, May futures prices for West Texas Intermediate (WTI) crude oil on the New York mercantile exchange (NYMEX) have fallen precipitously to $1.75 as the contract comes towards its expiration date. If the economic demand rebound in May and June in Asia and beyond does not materialize fast enough and at the large scale needed to absorb the world’s oil, continued oil price volatility could be harsh. Recent Chinese traffic data, for example, shows a strong resumption in driving of personal automobiles on the road during work related commuting hours but a still subdued amount of traffic at other times of the day when cars could have been expected to return to the road for shopping and recreational activities.  

If global oil demand does not pick up sufficiently in the coming weeks, then lack of access to physical oil storage facilities is bound to cause some oil production to shut-in. Analysts believe that oil production in Africa, Latin America, and Russia could be the most at risk to storage shortage-related curtailments, with potential damaging results for the long run performance of some older oil fields. The prospects that some oil exporters could be forced to close oil fields sooner than others means that all producers have some incentive to take a wait-and-see approach to their promised cuts. In recent years, the collapse of Venezuela’s industry has made room for better prices for the rest of OPEC. Loss of exports from war-torn Libya has also helped.  

Despite all the uncertainty or maybe because of it, Russia and Saudi Arabia released a joint statement last week saying that they will “continue to monitor the oil market and are prepared to take further measures jointly with OPEC Plus and other producers if these are deemed necessary.” At the same time, analysts are struggling to anticipate which will come first, a gradual recovery of oil demand as various countries or regions reopen their economies, or damage to oil fields whose operations can no longer continue normally due to financial bankruptcies, severe economic losses, lack of access to storage, or worse still, a severe outbreak of coronavirus among critical offshore workers in a particular location or platform. The uncertainty is bound to create a volatile mix for oil prices in the next few weeks and complicate any future international diplomacy to bring longer range stability to oil markets.