Sinking Oil Prices in the Time of COVID-19
When the markets opened on Monday, March 9, in Asia, oil prices crashed by more than 30% from Friday’s close of $31 a barrel. That was the lowest price since early 2016, before the OPEC-Plus alliance was founded. To get a better grasp on the oil market’s volatility and how coronavirus played a role, GLG spoke with Dr. Carole Nakhle, Chief Executive Officer of Crystol Energy and an energy economist, on March 11. The below Q&A was edited for length and clarity.
Can you provide background on the Saudi-Russian relationship up until this past week?
In December 2016, OPEC joined forces with several non-OPEC producers, led by Russia, to introduce production cuts and stop oil production from falling further. The “partnership” became known as OPEC-Plus, the biggest partnership in the oil industry’s history. Then, the agreement was to take a total of 1.8 million barrels a day (mb/d), with OPEC – mainly Saudi Arabia – shouldering 1.2 mb/d, and the rest (600,000 barrels a day) was to be covered by non-OPEC producers, led by Russia. Originally, the deal was for six months but was renewed on several occasions because of the big challenge imposed by tight oil from North America. It was also helped by serious supply disruptions from countries such as Iran and Venezuela.
Last year, increasing supplies, particularly from the U.S., combined with concerns about weaker demand because of the U.S.-China trade war, put downward pressure on prices. It was a situation where even geopolitical tensions in the Middle East barely had any effect on oil prices. In December 2019, OPEC-Plus announced it would take out of the market another 500,000 barrels a day, in addition to the cuts it had previously agreed on. Then came coronavirus, which exacerbated the downward pressure on prices because of the uncertainty around global economy, trade, and, subsequently, oil demand.
In March 2020, OPEC suggested introducing further cuts of 1.5 mb/d. It is not formally known how that was going to be divided between non-OPEC (mainly Russia) and OPEC. However, what surprised many in the market was that Russia simply refused to take part and made no counterproposal. Saudi Arabia responded by drastically cutting its export prices, the largest such guts in 30 years, while significantly increasing production.
This was not the first time the Saudis reacted in this way; they’d done that at least twice since the founding of OPEC, in 1985 and 1998. Each time, they did it to reinstate discipline within the organization and strengthen their position as the leaders of OPEC and the most powerful player in global oil markets.
What do we know about Russia raising its output in retaliation?
Russia’s production can be increased to just above 11.5 mb/d from around 11.3 mb/d, currently. That level can be sustained after 2021. But the longer-term view is Russia’s potential is limited. The country lacks the advanced technology necessary to increase recovery rates in mature assets or extraction of unconventional resources and develop expensive offshore fields in the harsh conditions of the Arctic. If Russia continues to face sanctions that limit access to technologies, its industry growth will likely remain constrained for the foreseeable future.
There’s still a possibility of Russia being open to discussions with OPEC. Do you see a diplomatic solution soon?
It’s important to highlight one fundamental difference between the original two architects behind OPEC-Plus – Saudi Arabia and Russia – to understand the challenge ahead. That difference relates to the industry structure. In Saudi Arabia, all oil is produced by the national-owned oil company, Saudi Aramco. Russian oil production comes from several independent oil companies that must be brought together and agree on cutting production. The Russian tax code makes oil companies more exposed to higher oil prices because some fiscal instruments are imposed on a sliding scale for rising prices. The higher the oil price, the more taxes these companies must pay. As a result, every production-cut agreement with OPEC-Plus had to be imposed on the industry in Russia against the opposition of powerful CEOs.
Some believe that when Russia refused OPEC’s suggestion of cutting several hundred barrels of oil, it was bluffing because it hoped to get as low a quota as possible, and it did not really expect the Saudi reaction. To fix the situation now, it would have to accept a bigger cut. That’s why the chances are very slim on that basis alone, unless there are more politically driven factors that would bring OPEC and Russia back together.
What do you expect from non-OPEC suppliers?
For the next five years, the IEA expects the biggest increase in supply to come from the U.S., particularly from shale; Canada; Guyana; and Norway, in addition to OPEC members, such as Iraq and the UAE. Perhaps the biggest issue for now is U.S. tight oil; typically, conventional producers do not respond quickly to oil prices – this is what economists call an inelastic supply. The investment was done several years before and any increase in conventional oil production will be the result of that investment and not of current oil prices. U.S. tight oil, however, responds faster to prices. Instead of years, as is the case with conventional oil, the impact of its sensitivity to prices is felt in months.
Another interesting dimension is the investment strategy of some of the oil majors, such as BP, who, just a few months before the oil price collapsed, announced ambitious programs related to the energy transition, keeping in mind that such investments are not cheap. One wonders how these international oil companies will react to current oil prices, where returns and share prices have been slashed significantly. These companies are hit by a triple whammy: it’s not just low oil prices and falling demand, courtesy of the coronavirus, but also the increasing pressure to balance between their major portfolio of assets – that is, oil and gas – and their growing interest in investment in renewable energy and decarbonization.
What’s your guess as to where oil prices will go?
Under existing circumstances, we will likely see a prolonged period of low oil prices. There is no shortage of supply – the markets are flooded. On the demand side, the big uncertainty is the impact of coronavirus on global oil demand and economy.
The possibility of a public reconciliation of OPEC-Plus cannot be entirely dismissed, although this might be rather a show of goodwill than introducing significant cuts, at least from the Russian side. The Saudis might have to go it alone and reverse their course of action. Should this happen, then we might see a marginal recovery of current low oil prices – but not to the levels we saw last year – at least until the end of the year.
About Carole Nakhle
Dr. Carole Nakhle is the Founder and Chief Executive Officer of Crystol Energy, an advisory, research, and training company in London. As an energy economist, she specializes in international petroleum contractual arrangements and fiscal regimes, petroleum revenue management and governance, energy policy and investment, and global oil and gas market developments. She has worked in the oil and gas industry (Eni and Statoil), policy making (Special Parliamentary Advisor in the House of Lords), academia, and as a consultant to the IMF, the World Bank, and the Commonwealth Secretariat.
This article is adapted from GLG’s March 11, 2020, teleconference, “Oil Price Drop: Geopolitical Perspective.” If you would like access to this teleconference, or you would like to speak with Dr. Nakhle or any of our more than 700,000 experts, contact us.