Like a bat out of hell part two: The outlook for oil
The second in a five-part series from the BRG energy and climate practice looks at the impact of Covid-19 on the global oil market and the trajectory of its recovery.
Oil prices in the US and across the world have collapsed as a result of combined supply and demand shocks. Global oil production increased substantially after Russia’s refusal to cut production during the Opec+ meeting on 6 March, which provoked retaliatory production increases from Saudi Arabia and the UAE.
As part of a one-two punch, this supply shock was followed swiftly by a massive reduction in demand. Oil consumption plunged by c.29pc in April following the declaration by the World Health Organization (WHO) on 11 March that Covid-19 had become a pandemic. The knock-on effect on benchmark spot oil prices was immediate and dramatic (see Figure 1).
The economic impacts of the coronavirus have already prompted Russia and Saudi Arabia to suspend their supply competition with each other and US shale oil producers in an effort to stabilise the market. On 13 April, Opec and Russia agreed to resume Opec+ cooperation to reduce global production by 10pc—or approximately 9.7mn bl/d—for May and June. This will be reduced to a cut of 7.7mn bl/d from July through to the end of 2020. To this end, Saudi Arabia began reducing output at the end of April while Russia has prepared exports cuts from its Baltic and Black Sea ports, according to its preliminary loading schedule. On 11 May, Saudi Arabia announced its intention to reduce its output by another 1mn bl/d beginning in June, on top of the cuts already agreed by Opec+ in April. Following this announcement, the UAE and Kuwait stated their intention to further cut production by 100,000bl/d and 80,000bl/d, respectively.
The Opec+ agreement is contingent on the participation of other non-Opec members, including the US, Canada, Mexico and Brazil. As such, the US, Brazil and Canada have stated their intention to collectively contribute 3.7mn bl/d to the cuts as their production naturally declines because of market forces.
At the time of writing, it is unclear whether President Donald Trump’s administration can and/or will force a substantial reduction in the volume of oil exported by the numerous independent producers in the US, many of which now stand at the brink of bankruptcy. So far, oil-producing states, such as Texas, have refused to impose production cuts and are likely to leave the matter to market forces.
Unlike airlines, oil and gas companies will probably not see targeted support. But the Federal Reserve recently expanded its criteria for the Main Street Lending Program, increasing the pool of oil and gas companies qualifying for aid. A specific oil and gas industry bailout remains unlikely to pass Congress, however, as demonstrated by the Democrats’ recent efforts to block $3bn in spending to replenish the Strategic Petroleum Reserve.
April’s estimated collapse in global oil demand is already almost three times larger than the targeted supply reduction agreed by Opec+
Because voluntary production cuts and/or federal bridge loans appear unlikely to reverse the exodus of risk capital from the US E&P sector, the most likely outcome is that prevailing low prices will cause overall reductions in US oil production. In that regard, the position of oil and gas lenders and investors is entirely different than it was during the oil price collapses of 2008 and 2014, when investment and production were sustained. In the current environment, major US lenders are also preparing to seize oil and gas production assets to minimise further losses on their loans to heavily indebted companies.
As a result, the US Energy Information Administration (EIA) recently revised US production projections from over 13mn bl/d to approximately 11mn bl/d for 2021. This is a projected response to low prices rather than a government-ordered production cut.
The recent Opec+ supply cuts appear to be a case of too little, too late. It is especially striking that April’s estimated collapse in global oil demand is already almost three times larger than the targeted supply reduction agreed by Opec+ and endorsed by the G20. The WTI May futures contract recently fell into negative territory for the first time in history as US commercial storage became booked to the brim.
Given that the economic and oil demand recovery from the pandemic will likely be gradual and partial, the oversupply will worsen before it improves. This is shown by the collapse of futures prices for Brent and WTI, with prices for the latter having fallen into the $25-32 range recently for the June, July and August contracts (see Figure 2).
Additional supply cuts will probably be needed in mid-2020, but they would be extremely painful for leading suppliers and so may prove elusive. It is more likely that the level of near-term oil demand destruction will overpower the Opec+ supply cuts, yielding sustained downward pressure on oil prices.
As societies begin to lift measures to tackle Covid-19 in mid-2020, global oil demand will begin to rebound, but the recovery will likely be gradual and partial. Current estimates suggest that global oil demand will not reach pre-pandemic levels until at least late 2021 or 2022. The lifting of lockdown, social distancing and ‘essential travel’ policies is likely to be slow as governments seek to reduce the risk and magnitude of further outbreaks.
The pandemic’s effect on global oil demand has varied by consumption sector. A recent analysis from the Oxford Institute for Energy Studies (OIES) indicates that demand for transportation fuels accounted for 78pc of global oil demand destruction since December. The decline in demand for road transport and jet fuel declined by 23.5mn bl/d and 4.7mn bl/d in April, respectively.
c.29pc – Oil consumption drop in April
The pace of recovery in oil demand also is likely to vary by consumption sector. The International Energy Agency (IEA) projects a year-on-year decline in oil consumption in 2020 of 26pc for the airline industry, 7pc for diesel and 11pc for gasoline. Demand from the shipping and aviation sectors, which together account for 14.5pc of global final oil consumption, will likely be the slowest to rebound.
Following on from the shock to China’s maritime sector in the early months of the outbreak, companies will in the long-term look towards greater supply chain localisation and optimisation. This will only prolong the recovery in energy consumption from the global shipping industry. Similarly, it will likely be years before aviation demand rebounds to pre-pandemic levels, with one recent survey suggesting 60pc of people would “definitely or probably” not fly after lockdown restrictions are eased.
By contrast, there are signs that road transport—which accounts for nearly 50pc of global final oil consumption—may rebound more quickly than shipping or aviation. As businesses begin to reopen, employees may eschew public transport in favour of personal vehicles. This is happening in Berlin (one of the earliest European cities to reopen), where use of public transport is 61pc below normal as compared with only 28pc below normal for automobile use.
On balance, the combination of sustained structural supply competition between Opec, Russia and US shale oil producers and a gradual, partial recovery in oil demand means oil prices will probably remain ‘lower for longer’. This will impede new investment, lead to a wave of bankruptcies and restructurings, and destroy the less-economic sources of oil production.
This article is the second of a five-part series from the BRG energy and climate practice that analyses the near- and long-term effects of the Covid-19 pandemic on global energy markets, the energy transition and the climate-change imperative. The next article in the series will evaluate the knock-on effects of the oil market crash on the natural gas and LNG sectors.
Chris Goncalves is chair and a managing director of the energy and climate practice at Berkeley Research Group, LLC (BRG). He has 30 years of experience in the LNG, natural gas, thermal generation and renewable energy industries, with expertise in energy markets, economics and finance. He provides both expert witness and business advisory services.
Robert Stoddard is a managing director in BRG’s energy and climate practice. He has over 30 years of experience as an energy economist in the US and European electric power industry, both as an expert witness and business advisor. He is also CEO of an ocean wave energy technology company and a member of the Energy Working Group of the State of Maine Climate Council.
Alayna Tria is an associate director in BRG’s energy and climate practice. She specialises in financial, market and economic analysis for business advisory and dispute resolution in the areas of oil, natural gas, LNG and renewables.
Tristan Van Kote is a senior associate in BRG’s energy and climate practice. He provides analysis in the areas of power and natural gas markets, climate change policy and project finance.