The Fuse

Oil’s Long Road to Recovery

by Gregory Brew | June 08, 2020

There’s a sense of recovery in the air. Throughout the energy industry, cautious optimism has replaced the gloom-and-doom of April and May.

Goldman Sachs feels the outlook is “broadly bullish.” Meetings with shale executives confirmed that attitudes towards production and investment remain conservative, with cash-flow and de-leveraging prioritized over resuming the runaway growth that characterized the 2016-2019 period. Goldman expects prices to remain in the $40s for the next year.

American drillers, including Austin-based Parsley Energy and Midland’s Piedra Resources, are applying for drilling permits after a year-long pause. Parsley announced in June that it would be bringing back the “vast majority” of the 400 wells it shut down in March.

A sense of cautious optimism emerged from the OPEC meeting on June 6. Members of “OPEC+” agreed to renew productions cuts begun in April, with no signs of a new Saudi-Russian price war. Cuts of 9.6 million barrels per day (Mbd), which were originally meant to taper off on July 1, will be maintained through the end of that month. Prices rose in the wake of the meeting, breaking $40 on June 8 for the first time since March.

The bullish attitude, boosted in part by the dramatic recovery of the U.S. stock market, conceals the challenges facing the energy industry. The effects of the COVID-19 outbreak and the accompanying collapse in oil demand will be felt for many months to come, with significant repercussions on oil markets.

OPEC faces its perennial challenge—cheating. While the meeting went smoothly, a number of OPEC’s members are lagging in their commitment to cut production. Iraq, the biggest offender, has cut only 300,000 barrels per day, less than a third of its targeted output cut. Other members, including Nigeria, Kazakhstan, and Angola are dragging their feet.

Saudi Arabia is trying to take a firm line with cheaters. With production down and prices edging up, OPEC’s leader has the clout to force other members to keep cutting in the hopes that market conditions will continue to improve.

But the Kingdom faces an unprecedented economic crisis due to COVID-19 and the oil price collapse. Like the rest of OPEC, Saudi Arabia will need prices to increase well above $40 to meet its budgetary needs. Otherwise, it will be forced to take on more debt, drain its reserves, cut public spending, and even defund the national currency to stay afloat.

While OPEC triumphed in the short term, larger near-term challenges await the oil alliance.

And while OPEC triumphed in the short term, larger near-term challenges await the oil alliance. Libya is slowly emerging from a years-long civil war, and oil production is set to re-start for the first time since 2017. Pressure will build on OPEC to permit a Libyan recovery, as the nation’s oil is in high demand in Western Europe and will be needed to stabilize the country’s shattered economy.

While production cuts help to reduce inventories and boost prices in the short-term, ultimately OPEC+ will need demand to recover. And the best estimates for the year have demand coming in at 90 Mbd, nearly a 10 percent drop from 2019.

Gasoline demand in the United States has not recovered, even as major cities reopen. Gasoline stocks have been slowly declining, but are still high enough to keep gas prices depressed. While that might be good for the American consumer, gasoline demand has been ticking slowly upward, from 6.79 Mbd in mid-May to 7.5 Mbd by month’s end, well below the June 2019 level of 9.4 Mbd. When, or if, American drivers return to their cars and resume consuming gasoline at previous levels remains an open question.

Drillers are already bringing back shuttered production. But bankruptcies continue to shake confidence. Some of the big names to go down include Diamond Offshore Drilling, Whiting Petroleum. Chesapeake, a pioneer in the shale sector, announced in May that it was considering filing for Chapter 11, in view of its $1 billion debt load. BP, which announced a sweeping plan last year to achieve “net zero emissions,” has indicated it will reduce its workforce by 15 percent, cutting 10,000 employees, in another sign that larger companies are expecting a prolonged period of retrenchment, mirroring the last price downturn of 2014-2015, when investment in new production plunged by 35 percent.

While drillers and traders have welcomed the recovery in prices, $40 is nothing to celebrate.

While drillers and traders have welcomed the recovery in prices, $40 is nothing to celebrate. Ryan Sitton, the out-going member of the Texas Railroad Commission, warned on June 5 that prices were not sufficient to return U.S. companies to profitability. Moreover, Sitton notes that before prices crashed in March, a declining rig count and slowing issue of drilling permits indicated the US patch was headed towards a downturn, without the shock of the COVID demand crash.

To sustain the 2017-2019 level of activity, Sitton estimates Texas would have to issue “around 300 permits a week,” with prices at $70 or above.

Rather than a V-shaped recovery in the short term, Sitton predicts a more dramatic price spike in 2021, as under-investment during the COVID period will leave insufficient supply when demand returns. That may mean “banner years” of $100-plus after 2022, but it also means pain, bankruptcies, layoffs, and uncertainty in the short-term.

Despite the current cautious optimism, oil’s road to recovery is likely to be long, slow, and defined by uncertainty. There are geopolitical factors to consider. OPEC’s ability to enforce cuts may be mitigated by the return of Libya, political demands for higher revenue in OPEC states including Iraq and de facto leader Saudi Arabia, and the brittle solidarity of the OPEC+ alliance, a union which nearly collapsed in April.

Recovering prices and the slow return of demand is certainly cause for optimism. But there’s a long way to go before producers can breathe easy again.