The Fuse

OPEC and Russia Start Price War

by Nick Cunningham | March 09, 2020

The OPEC+ talks collapsed on Friday, and OPEC and Russia have kicked off a price war. Oil prices immediately went into free fall, plunging by roughly 10 percent on Friday and by another 25 percent on Monday.

These are uncharted waters. In the past, an OPEC price war was not accompanied by a global pandemic and shrinking oil demand. If unrestrained production continues for any lengthy period of time, there is little reason to think oil can stage a rebound in the short run.

OPEC+ collapses
There were signs in recent weeks that OPEC+ was going to struggle to agree to additional production cuts. Russia had repeatedly signaled that was not keen on cutting deeper, having already agreed to additional cuts just a few months ago.

Most analysts either thought the OPEC+ coalition would cut by between 600,000 barrels per day (b/d) and 1 million barrels per day (Mbd), or OPEC would cut by some modest amount without Russia’s participation. However, few predicted an absolute collapse of the OPEC and non-OPEC coalition.

Russia and OPEC walked away from Vienna without a deal. Worse, they appear to be abandoning market management altogether, setting up a dynamic in which everyone produces at will. Saudi Arabia announced a steep cut to the price of its oil, a signal that it intends to pursue a price war. An “oil price war unequivocally started this weekend” said Damien Courvalin, head of energy research at Goldman Sachs, according to the Wall Street Journal. Saudi Arabia could produce over 10 Mbd in April and conceivably ramp up to 11 Mbd.

The lack of supply curtailment has not occurred since before the initial round of OPEC+ cuts at the start of 2017, which was a response to oil prices hitting a low-point in February 2016 below $30.

Already, oil prices are approaching that nadir. As of Monday, WTI was at $30 per barrel, falling by the most in a single-day in three decades.

“The radical shift in policy suggests that Saudi will allow inventories to build sharply over the next three quarters, pushing oil markets around the world into supercontango,” Bank of America Merrill Lynch wrote in a note. “As a result, we now expect Brent oil prices to temporarily dip into the $20s range over the coming weeks…Brent prices could even drop into the teens.”

The investment bank said it is “still important to find out whether this new Saudi price action is being waged against Russia or against US shale.” If Russia is the target, then there is a chance that talks could resume, Bank of America said. If OPEC is trying to kill U.S. shale, then the market bust will last much longer.

But Russia responded on Monday with indifference (at least outwardly), saying that its budget could withstand oil prices at between $25 and $30 per barrel for 6 to 10 years. Saudi Arabia also has a big stash of cash reserves to fall back on, but it also has high budgetary requirements and a fixed exchange rate to defend. It’s not clear how long either side can hold out.

“From Saudi Arabia’s perspective, Russia seemed to be getting a lot of reward from the arrangement with very little effort on its part,” Standard Chartered wrote in a note. “Russia for its part also seems to  feel aggrieved; before the OPEC+ meeting some policymakers and energy CEOs expressed a view that Russian output restraint had only benefited US shale oil companies.”

Demand to fall for first time in a decade
Oil demand is on track to shrink for the first time since 2009 during the depths of the global financial crisis, according to a new forecast from the International Energy Agency (IEA). “In the past few weeks, Covid-19 (coronavirus) has gone from being a Chinese health crisis to a global health emergency,” the IEA wrote.

The agency said that oil demand could fall this year by 90,000 b/d, a remarkable change from the agency’s 1.2 Mbd growth estimate from two months ago. But even that rests on some variables trending in a positive direction. For instance, that scenario assumes China brings the coronavirus “under control” by the end of the first quarter, and while the virus begins to have a larger impact on Europe and North America, the demand hit is more modest.

All told, the agency sees demand growth “only slightly lower” in the second quarter from a year earlier, which, could prove optimistic. After all, the question of demand is not only one of containment measures that ground flights, idle factories and keep people from driving for a period of weeks.

As the volatility in financial markets demonstrate, the global pandemic may yet result in deeper economic turmoil. The Dow Jones Industrial Average fell by more than 6 percent on Monday, temporarily halting trading due to excessive volatility. Some analysts see an economic recession as all but inevitable.

Price war and demand destruction
The problem for the oil market is that two simultaneous crises are unfolding at the same time: a gargantuan supply surplus is about to hit the market at a time when demand is contracting. In that sense, the current situation is unlike the 2014-2016 downturn (an oversupply crisis) or the 2008-2009 financial meltdown (a demand crisis). Both are occurring at once.

The hit to U.S. shale could be quick and severe. Energy E&Ps saw their share prices crater by 20, 30 and even 40 percent in some cases on Monday. Just about no company can make money with WTI at $30 or below. Morgan Stanley says defaults in the sector will exceed that of 2016 (when 70 companies in North America declared bankruptcy). The investment bank singled out Chesapeake Energy and Whiting Petroleum as two companies that are at near-term risk of default.

There are two main ways the oil market can back to something resembling a balance. First, OPEC+ comes back to the negotiating table, which now seems unlikely. Second, the market balances after a period of time with prices at rock bottom levels, forcing some drillers out of business. Standard Chartered said the latter is more likely, with U.S. shale bearing the brunt. The bank sees U.S. oil output falling by 0.5 Mbd this year from current levels, with “risks to the downside.”