Commodity Analysis

Will the crude oil rout continue?

Anand Kalyanaraman | Updated on March 15, 2020 Published on March 15, 2020

Demand is weak and supply aplenty. But pragmatism may prevail between Saudi Arabia and Russia

The past week, crude oil prices fell off the cliff. In just two trading sessions, Brent fell nearly 35 per cent to about $32 a barrel on March 9, a level last seen during the previous oil rout in 2016. The latest crash followed an unexpected no-agreement on March 6 among the members of the OPEC+ group (primarily Saudi Arabia and Russia) on extending their output cut deal to stabilise already weak prices.

No deal

Just about three months ago, in December 2019, the OPEC+ group had decided to deepen its output cuts from 1.2 million barrels a day to 1.7 million barrels a day, effective January 2020 until March 2020. But this move, in response to risks of weak demand growth and oversupply conditions, did not prove a match to the oil demand destruction worries due to the global spread of the coronavirus. Brent had already fallen from about $65 a barrel as of end-December to about $50 a barrel until March 5; this was despite a sharp escalation in US-Iran tensions and worries of oil supply shocks due to the assassination of top Iranian military general Qassem Soleimani by the US government on January 3.

To support prices, Saudi Arabia wanted the OPEC + group to cut output by a further 1.5 million barrels a day, reportedly through 2020. But Russia, somewhat a reluctant partner even earlier, baulked — it did not want the US shale oil industry to benefit from higher prices. Ergo: the OPEC+ output cut deal — even the existing 1.7 million barrels a day was off, with players no longer constrained by production quotas. This unravelling of the OPEC+ group, the cartel producing most of the world’s oil, heralded a price war for market share gains, and sharply worsened oil’s rout.

Saudi Arabia fired the first salvo by slashing its official selling price and indicating a major ramp-up in its output — from about 9.7 million barrels a day in recent months to 12.3 million barrels and further to 13 million barrels a day, going forward. The Russians, too, have indicated their intent to retaliate by ramping up their output.

The game plan seems to be to flood the market with cheap oil to garner as much market share and hurt rival producers.

Outlook

 

Will the rout in oil prices continue? On one hand, demand for oil remains very weak due to the impact of coronavirus on economies across the world. The International Energy Agency recently said that compared with 2019, global oil demand in 2020 could fall by 90,000 barrels a day to 99.9 millions barrels a day — the first such contraction since 2009. On the other hand, the price-war-for-market-share game being played out by major producers will result in huge oversupply. The combination of weak demand and oversupply could extend oil’s rout further. Some analysts predict that oil could go as low as $20 a barrel.

But that need not necessarily be the case. Pragmatism could broker a compromise between the warring suppliers. All oil producers — including Saudi Arabia and Russia — will be financially badly impacted by the oil price crash, and many shut-downs and bankruptcies can be expected, especially in the US shale oil industry and in smaller producing countries.

While Saudi Arabia’s cost of oil production is among the lowest in the world and it has big spare capacity to ramp up production, its economy is heavily dependent on oil revenue. According to reports, the country needs oil to be at around $80 a barrel to be able to balance its budget.

Oil at $35 a barrel or lower could see the country’s deficit spike, hamper its growth plans and dent its formidable, but already-reduced, forex reserves. It doesn’t help that the Saudi riyal is pegged to the US dollar, leaving the country with less wiggle room on the currency adjustment front.

Russia has the advantage of a floating-rate currency and is relatively less dependent than Saudi Arabia on oil revenues.

The Russians recently said that they can manage with oil being at $25 a barrel for a decade. But this could be an optimistic estimate for the galleries. Also, similar to Saudi Arabia, oil is among Russia’s largest exports, and prolonged low prices cause the country big financial stress. Both Saudi Arabia and Russia are facing weakness in economic growth, and rock-bottom oil prices will be the last thing they need.

It is plausible, therefore, that the warring parties may come to a compromise sooner than later.

The price-war unleashed by the Saudis may be intended to get the Russians to the negotiating table and reach a middle ground on the output cuts. An agreement between the two, if and when it happens, could see oil prices again go to levels of $50 or so a barrel. A rally beyond that seems unlikely as long as demand conditions remain subdued due to the coronavirus impact. Until Saudi Arabia and Russia call off the ‘who blinks first’ game, Brent may trade in the $30-35 a barrel range. The lowest that Brent oil went to during the last rout of 2014-16 was about $26 a barrel; it is currently at $33.5 a barrel.

Amid the wrestling between the Saudis and the Russians, many US shale oil producers will be badly hurt. But the industry is unlikely to disappear. For the US, its shale industry has become a strategic geo-political asset, and the US government can be expected to provide it the financial cover to survive the storm.

Published on March 15, 2020
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