March 9, 2020
Last week, the Organization of Petroleum Exporting Countries (OPEC), along with a grouping of other countries, including Russia, that have for the last three years formed something known as the OPEC Alliance, or OPEC+, tried to reach an agreement to cut additional oil supply from the market in response to the coronavirus-induced oil price decline. It didn’t work.
Despite clear indications that Russia was not in favor of cutting further production, OPEC, led by Saudi Arabia, proposed a sizeable additional cut of 1.5 million barrels per day through the end of June and an extension of the existing supply cut through the end of the year. Russia walked away and the deal collapsed. Over the weekend, news stories circulated that Russia wanted to see oil prices decline in order to harm U.S. tight oil producers. Saudi Arabia cut their official selling prices and have reportedly decided to increase production to 10 million barrels per day or higher in the coming months, sending a strong signal that they have no desire to lose market share to anyone else. As a result, oil prices dropped 30 percent when the market opened in Asia, and at least one prominent forecaster warned oil could see the $20 barrel range with significant risk to the downside.
The economic impact of the coronavirus and its downward pressure on oil prices is hard to overstate. The International Energy Agency now forecasts a decline in oil demand this year for the first time since the 2008 Great Recession. Coronavirus aside, a collapse in the OPEC+ arrangement was bound to happen at some point. OPEC had been playing an increasingly complex game requiring it to not only weigh market fundamentals (supply, demand, stock levels, etc.) but also to gauge geopolitical factors involving U.S. sanctions (against Iran, Venezuela, and Russia); a U.S.-led trade war with China; the divergent interests of various OPEC members, including the bromance of convenience between Saudi Arabia and Russia; and a fundamentally new paradigm for the oil market in which most forecasters see peak demand for oil in the next couple of decades. Just a few months ago, 2020 looked to be a promising year with supply and demand coming back into balance, the careful tapering of the heretofore breakneck pace of U.S. oil production growth, and a ceasefire in the U.S.-China trade war escalation. Things were looking up for the oil-producing block of nations. However, this optimistic scenario was always precarious. Time and again over the last several years, U.S. tight oil production has outpaced expectations, but the economy did not show robust demand growth. Without these underlying conditions improving, the strategy of limiting supplies on the market would have to give at some point lest OPEC+ producers cede their market share to U.S. producers.
This oil price war is exceedingly complex, however. On one hand, there are all the geopolitical factors at play in the oil market. Iran and Venezuela are still sidelined by sanctions. Libya is in the midst of domestic struggle for power dividing the international community. The U.S-China trade truce is hanging in the balance as China’s economic outlook dims and living up to the increased purchases of U.S. goods outlined in the phase one agreement looks more difficult. On the other hand, there is a demand-shock driven by lower economic growth resulting from the coronavirus outbreak. In this situation, lower oil prices may not stimulate much new demand until the threat of the coronavirus dissipates. At least for now, the outbreak appears to be spreading, with new infections popping up all over the United States and other countries, as more and more people are being tested. Furthermore, after the recent Saudi Aramco IPO, the company cannot afford for its stock price to fall for extended periods of time without experiencing investor pressure.
OPEC had been operating under the notion that selling a smaller number of barrels at a higher price is in everyone’s best interest. Given this logic, producers should want this price war to stop as soon as possible unless a producer can expand its market share, which is likely part of the maneuvering that will take place in the coming days and weeks. The severity and speed of the Saudi response could indicate their desire to make the price drop deep and quick in order to bring everyone back to the bargaining table as quickly as possible. But a recovery of oil demand is outside the group’s control, and some countries can weather the oil price decline better than others. Russia came out on Sunday to say that it could cope with lower prices. Other OPEC countries are not so lucky and will be seriously impacted by the lower price environment the longer it lasts.
If it is true that Russia’s motivation is to harm U.S. tight oil producers and drive them out of the market, this is a double-edged sword. On one hand, smaller producers don’t have the same access to a never-ending pool of cheap capital anymore and could be driven out of business by lower prices. On the other hand, bigger tight oil producers have hedged against low prices and can weather the storm awhile. Finally, the experience of the last precipitous oil price decline in 2016 showed that lower prices brought additional cost discipline to the U.S. oil patch and ultimately made it a more competitive industry today. Here too, the U.S. oil industry will be fine, but individual companies and even communities will be hard hit and are not adequately prepared to deal with an oil bust, especially alongside a burgeoning public health crisis. For their part, oil companies will have to test their strategy of enduring a lower-for-longer price environment to one where very low prices will test their dividend strategies or their appetite for consolidation.
Untangling the economic and geopolitical implications of the oil price war could also be difficult because the larger macro environment is struggling to deal with the coronavirus. Stock markets are already a mess, spurring the call for protective and stimulus measures for affected economies. At the same time, fighting the coronavirus is leading to shutting down schools, major conferences, and travel, which will continue to have a chilling effect on economic activity. A lower oil price may wreak havoc on countries in the Middle East already teetering on the brink of full-fledged instability, like Iran, Iraq, and Libya. Finally, from whom will oil-consumer countries buy their crude and products during an oil price war? The lowest-cost supplier seems the obvious choice but perhaps not in a world where countries are competing for market share in such an aggressive fashion.
All of this should serve as an important reminder of two basic facts. First, oil markets remain interconnected, and what happens in oil producing countries around the world still impacts the United States. So much for energy independence. Second, there may be an energy transition underway for which many oil-producing countries are trying to create a long-term strategy for future competitiveness. But today, oil still matters a great deal to their life and livelihood, and in the current energy arena at least two major producers have decided it’s time to do battle.
Sarah Ladislaw is senior vice president and director and senior fellow of the Energy Security and Climate Change Program at the Center for Strategic and International Studies in Washington, D.C.
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