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What to expect from a potential 10-15 mbd OPEC++ cut

03 Friday Apr 2020

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After yesterday President Trump tweeted about it, there is today continuous noise about a possible OPEC++ (global coalition of all crude oil producers) meeting next week with the expectations of substantial cut in production, anywhere between 10 to 15mbd. On one hand, if this materializes, it will be an unprecedented (not counting the 1970s oil embargos). On another, it will barely go to match the lost demand from the (almost) whole world going on economic standby for at least a month, maybe much longer on the back of COVID-19.

Let’s put this into context. We got a 25% decline in oil prices (from low 40s on WTI to low 30s) when Saudi Arabia and Russia (OPEC+) could not agree on a 1.5mbd cut a month ago, and Saudi instead announced they ‘might’ increase production by 1.5-2mbd (but as of yet they really haven’t). Arguably, if they had agreed on a cut, oil prices may have rallied a bit, maybe to mid or high 40s.

But then we got another 30% decline (from low 30s to low 20s) when the negative effect of COVID-19 on demand became more evident. In an alternative reality if OPEC+ deal had happened a month ago, prices could have then collapsed to the low to mid 30s (30% off mid to high 40s). Don’t forget that oil had already sold off about 30% YTD at the time of pre-OPEC+ no-deal weekend. These are the milestones to keep in mind when considering the scenarios ahead of a possible crude production cut in the next few days. 

So, this is the way I am looking at this:

  1. The likelihood of ‘everyone’ (not just Saudi and Russia, but OPEC++) really agreeing on a 10-15mbd cut is very close to nil;
  2. But the likelihood of a ‘fudge’ agreement is very high.

‘Everyone’ benefits from a ‘deal’, even the oil importers as crude has become the main sentiment indicator and that would help risk assets: OPEC++ could decide to announce a ‘deal’ simply to stabilize the market with the idea that no one is expected to really cut production (perhaps negative effects of COVID-19 eventually wear off and demands comes back0.

Reality is that, in a similar manner to Saudi Arabia not really ‘wanting’, or, arguably, even being unable to hike production by 2mbd (they have never really managed to sustain production above 12mbd), no one really intends to, or is willing to go the other way (cutting production may actually entail lost capacity for ever). So, in both cases, everybody is playing the waiting game and hopes to do nothing. But the trick is in delivering the right message.

But what could happen to crude prices if there is an announcement of a 10-15mbd cut?

One would expect that the low range point of a bounce would be the low-to-mid 30s on WTI (where prices would have been, had a cut happened between Russia and Saudi Arabia a month ago, and the demand lost we can project at the moment from COVID-19). We are just above 30 on WTI as of right now, on Friday close. But given the much larger cuts this time, the high point of the range could indeed be the low 40s where prices were before the Russia – Saudi deal fiasco.

What happens if there is not even a ‘fudge deal’ in the coming few days? We go back to the low 20s immediately and then we wait to see how much more demand is destroyed.

Oil: OPEC’s Russian Roulette

08 Sunday Mar 2020

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I did not expect the ‘no deal’ from OPEC+ largely because of the urgency of the immediate demand destruction from the Coronavirus.

In hindsight, Russia’s reaction was quite rational. What about the Saudis?While they are still the lowest cost producer, the precariousness of the political situation there (see developments this weekend) makes me believe that they have a lot more to lose from the current status quo. Russia may be at a disadvantage when it comes to cost, but after years of sanctions, it is more prepared to withstand lower prices for longer.

As a result, I see Saudis’ attempt to lower prices on their products as a ‘bluff’, which, if called, they will have to fold. On the long run, lowering prices can only be counterproductive for them. First of all, it will affect their fiscal balance. Second, it will reinforce Russia’s (supposed) game plan (to push US shale out of the game) and hurt US, a Saudi ally. Therefore, this is at best an attempt to gain marginal market share; it would be extremely imprudent to begin a price war.

While indeed Trump has been very vocal on the benefit of low oil prices to US consumers, the sands started shifting in 2019 as the US became a net exporter of petroleum towards the end of the year: all of a sudden, Trump started extolling US energy independence. Would the US president be eager to keep a campaign promise to end US reliance on foreign energy? If so, he would now need to balance low oil prices with the risk of the US shale oil industry going bust. Therefore, I would not be surprised if the Saudis get a call from the White House should oil prices continue to plunge and that threatens the viability of US energy production.

I think the short-term market reaction this week will be brutal, but this is very different from 2014-2016 when we had similar producers’ dynamics and oil hit $30. First, inventory build-up back then was +230mbd, today it is -1.5mbd. Second, shale was in the upswing then, while now it is on the backfoot: oil-well declines are much bigger, costs are higher, and capital is scarcer. 

I was bullish WTI at $45 last weekend partially because I expected the markets to bounce on sentiment, which they did, but more importantly, because the price reflected a demand-supply imbalance discounting a sharp drop in demand from the Coronavirus effect – there was, I thought, a decent cushion. Moreover, it is my view that either China will use the oil price drop to simply buy more oil, or that economic activity in China, being the marginal swing buyer of oil, will slowly come back – or rather much faster than in the West thanks to the actions the authorities there took to contain the outbreak.

Oil eventually hit $30 in 2016 but did not stay there long. It is much more difficult to model today the demand destruction from the Coronavirus but also there should be some marginal energy demand coming from the digital medium as all these people staying/working from home get online (ICT energy use is now more than half travel energy use, and it is growing very fast). Supply side is always easier to model, and it shows that compared to 2014, inventories are much lower, shale is largely out, and specs are short.

We should not underestimate that lack of liquidity/margin calls work both ways depending on positioning (as per gold sell-off a week ago) That means one needs to watch the newswires and trade rather than invest. That’s what I am doing.