Opec+ deal failure sends oil spiraling
Brent price falls from $45/bl to $25/bl in early trade, before partial recovery to $36/bl at 10am, as production surge threatened amid weak demand
Global oil markets were sent into turmoil on Sunday off the back of the Opec+ group’s failure to agree a production reduction target. It signals an end to the post-2016 policy of protecting price at the expense of losing market share, and implies the group could produce far more than expected at a time of sharply falling demand.
Poor oil demand forecasts had weakened sharply due to the spread of Covid-19, on top of an already subdued outlook. “The potential for a strong recovery remains a distant prospect,” says Niamh McBurney, head of Mena at global risk consultancy Verisk Maplecroft.
“A production free-for-all has the potential to hurt vulnerable Opec producers, such as Iraq and Nigeria that have relied on prices in the mid-60s to keep their economies from recession amid a variety of headwinds including a suboptimal global economy and domestic political challenges.”
If benchmarks including Brent and WTI remain at sub-$50/bl levels—not seen since 2013—for an extended period, it would severely damage producing countries’ finances and cause financial markets to question the value of their debt.
“This ‘even lower for longer’ price environment could persist for weeks, if not months, [so] a number of Middle East producers will again find themselves in challenging fiscal circumstances,” says McBurney.
Middle East producers—notably Saudi Arabia with its Vision 2030 programme and partial floating of Aramco—have sought to diversify their sources of income and reform their economies but have not been entirely successful.
“Efforts have not yielded the required results to shift their revenue base substantially away from hydrocarbon receipts,” says McBurney. “The sovereign debt profile of a number of Opec producers will now be called into question as market participants try to anticipate how long this continues and at what point this poses a threat akin to that of late 2014.”
She adds that Opec’s previous oil market policy levers have proven wanting when demand rather than supply is what constrains consumption.
A return to the pre-2016 policy of protecting market share will prompt at least short-term volatility which will have ripple effects across the global economy.
“This raises questions as to how effective this 180° turn will be when fundamentals, with the US’s role as a key producer now firm in the market, are so different to just a few years ago,” says McBurney. “We do not expect the taps across Opec members to open wildly—the uncertainty of who will produce how much more will contribute more strongly to the sense of uncertainty than actual production in and of itself, we believe.”
Saudi Arabia and Russia are apparently banking on the potential surge impacting US shale production. They are hoping that it causes producers to retrench and allow Opec+ countries to return to their pre-2016 positions.
Rystad’s head of oil markets Bjoernar Tonhaugen says: “Saudi Arabia’s shock-and-awe strategy by slashing prices to customers for April loadings on Saturday has caused the largest oil price drop in a single day on record during the Asian open this morning.
“The price volatility may lead to bankruptcies among trading firms, while others will thrive. Markets are driven by greed and fear, but among these two emotions, fear is again strongest.”
Before the Sunday bombshell, US shale producers were widely thought to be eying an increase in production. For example, Rystad Energy’s analysis of the latest shale E&P guidance found that light oil production in the US was guided to grow by 8.1pc year-on-year—but this is certain to be revised down after the weekend’s events. Capital expenditure is likely to fall hard—Rystad Energy already expected a decrease in capital expenditure of 11pc, compared to 2019, before the weekend’s events.
Gas and LNG
The recent tumble in oil prices is not likely to be mirrored by spot gas prices, however, according to Carlos Torres Diaz, Rystad's head of gas and power markets.
“European gas prices have decoupled from oil since the end of 2018 as a result of the supply glut across the continent, which have led the TTF front month contract to trade at record low levels of less than $3/mn Btu.
“If gas prices were to drop any further, we should see a downward adjustment in LNG exports from the US to Europe as exporters of spot cargoes would not be covering their operational costs if prices drop further. Also, long-term contracts in the region were renegotiated to remove oil-indexation and are now mostly indexed to gas hubs reducing the effect that oil has over gas price movements.”
He adds that LNG spot prices in Asia are at record-low levels of close to $3/mn Btu and “can hardly go any lower as exporters of spot cargoes are already struggling to cover their operational costs”.
However, he notes that the tumble in oil prices does affect oil-indexed contracts and this will have major implications.
“It will hit the revenues of LNG projects that are exporting most of their volumes through oil-indexed long-term contracts. It reduces the price ceiling for LNG spot prices. During a normal cold winter, LNG spot prices tend to increase toward oil-indexed levels to attract more LNG supplies into Northeast Asia and Northwest Europe.
“With oil prices at $60/bl the price ceiling is somewhere above $7.5/mn Btu. However, if oil prices remain at around $35/bl for a long period of time this reduces the oil-indexed gas price to as low as $4.4/mn Btu slashing the hopes of LNG exporters to see a brighter price environment during the coming winters.”