Is the Worst of the Oil Crisis Behind Us?
April 2020 will be remembered as the bleakest month in the history of oil markets in terms of balances and prices. But looking ahead, there are signs of improvement both on the supply and demand fronts, though from a very low base. Many countries have started to ease the coronavirus-induced lockdowns which is expected to have positive impact on oil demand. On the supply-side, OPEC+ cuts will come into effect, while the supply responses outside the OPEC+ producers have been fast and severe. The impact of these factors is already being felt on oil prices and physical markets.
In this Energy Comment we explore the range of uncertainties surrounding the post-crisis recovery of market balances and prices and assess the key factors that will shape oil market outcomes in 2020 and 2021. We identify the shape of the recovery of oil demand as the key factor dictating the rebalancing process. The oil market balances are also sensitive to OPEC+ compliance. If OPEC+ producers fail to abide fully by their quotas, the market rebalancing will be delayed till the end of 2020. The final factor determining the sensitivity of oil balances is the extent of supply reductions outside OPEC+. Unlike the 2014-2016 cycle, which came at the back of a sustained period of Brent prices above $100/b, the scale of the current demand shock is much bigger, and the financial position of all players is relatively weaker and therefore the supply contractions/production shut-ins will be deeper and faster in this cycle.
The current oil shock and the transformation of the supply curve as a result, will present some opportunities to low cost producers with ability to increase production, particularly to Saudi Arabia. If the demand recovery proves to be stronger than expected, the Kingdom may find itself in a position to increase production and capture market share by substituting for production losses elsewhere (high output / low price). But this may require that prices remain in a range of $40-50/b so as not to encourage rapid supply growth in other parts of the world and to support the demand recovery. With higher production and more importantly higher exports, this strategy may result in similar payoff to a strategy of lower output and higher prices say in the $60-70/b range (low output / high price). But the higher output/lower price strategy has additional advantages. First, this is consistent with an array of existing domestic policies aimed at improving efficiency of energy consumption, energy pricing reforms, and increasing the share of gas and renewables in the power sector which will reduce domestic demand and free crude for exports. Second, by increasing production, the Kingdom can engage in faster monetization strategy at times when there are concerns that the energy transition will result in lower long-term demand for oil. Third, given that oil production still constitutes a significant part of GDP, higher production can support overall Saudi GDP growth. Fourth, when the next cycle arrives, Saudi Arabia can negotiate cuts with other producers from a much higher base. Finally, if the US shale supply response turns out to be weaker than in previous cycles because investors require higher price in order to be attracted again to US shale, especially in the aftermath of the shock of negative prices, then Saudi Arabia can increase both its exports and revenues.