VIRUS ATTACKS OIL

March 2020 was truly a 'black month' for the global oil production. The coronavirus epidemic had a huge impact on the global oil market, causing a decrease in fuel demand. The meeting of the ministers of member and non-member states of OPEC renewed hopes concerning the situation. However, the outcome of the meeting exceeded all expectations: the OPEC+ cooperation format to reduce oil production and to ensure stability in the market collapsed after three years due to the disagreement of its main initiators—Russia and Saudi Arabia, which caused the collapse of oil prices.

OPEC has become different

Assumptions that the OPEC+ fails and loses its effectiveness has sounded more than once during the term of the deal. However, no one expected that the format would collapse instantly at the most undesired moment for the market.

The terms of the last OPEC+ deal signed in December 2019 provided for a total reduction of oil production in the first quarter of 2020 by 1.7 mbpd from October 2018.

During the March 5 meeting in Vienna, OPEC ministers agreed that OPEC+ should be extended until the end of 2020, trying to reduce the production by another 1.5 mbpd. At the same time, the cartel was ready to take on an additional production decrease by 1 mbpd, provided that the remaining 500,000 was distributed among the  non-member states. Saudi Arabia was an active supporter of the deeper reduction. It is possible that under the pressure of Riyadh the cartel changed its decision twice a day—in the afternoon, it agreed on an additional reduction of 1.5 mbpd only during 2Q2020, and in the evening—proposed to extend it until the end of 2020.

Russia insisted on going on without additional cuts and extending the current deal until the end of 2Q2020. Disagreements between the main parties to the agreement arose earlier, but this time no compromise was reached. As a result, the OPEC+ ministerial meeting on March 6 ended to no avail, since Russia and Saudi Arabia could not reach a consensus.

This means that the oil deal concluded at the end of 2016 is no more applicable and the OPEC+ members do not have obligations to reduce production. The next OPEC meeting will be held in June.

If we take into account the reluctance with which Russia agreed to extend the deal back in December last year, we can conclude that Russia's withdrawal from the deal was predetermined.

"We signed a joint document to continue our coopearation within the framework of the OPEC+ Cooperation Charter. As for reductions, our recent decision assumes that none of the member and non-member states of OPEC have obligations from April 1, 2020," the Russian Minister of Energy, Alexander Novak, said.

OPEC Secretary General Mohammed Barkindo expressed optimism and confidence that none of the OPEC+ members wants to repeat the situation of past years when the oil prices were low. "We had discussions with Russia, and they are committed to the declaration of cooperation. They want to continue. We still believe that they return to the Noah's Ark," M. Barkindo said.

Barkindo said that 90% of non-member states of the cartel agree with the OPEC decision. It is necessary to convince "one or two countries" to accept the position.

The situation has become especially dangerous after the changes in the oil market coincided with the shock caused by the drop in global demand for raw materials due to coronavirus.

The market reacted to the failure of the OPEC+ negotiations almost immediately. On March 6, the price of Brent oil sharply accelerated before it fell by 7.5%. The cost of May futures on the London Stock Exchange fell to $46.26 per barrel. April futures for WTI on the New York Mercantile Exchange (NYMEX) fell 7.6% to $42.42 per barrel.

Response

The first victim of sharp decline in prices was the state-run Saudi oil company Saudi Aramco. Its stock price fell below the IPO price on March 8 for the first time since the company entered the exchange. Securities lost about 9.1% in value.

After the collapse of negotiations on the new OPEC+ deal, Riyadh announced plans to increase own production from April from 9.7 million to 10-11 million bpd (if necessary, above the record 12 million bpd) with the lowest price possible price—20% discount.

As a result, the largest drop in oil prices since the 1991 Desert Storm operation was recorded on March 9. World markets plunged into chaos, shares of Russian companies collapsed.

Oil lost almost the third of its price, dropping to $31 per barrel for Brent, while the American WTI fell below $30. After some corrections, the price increased to $36, but a drop of 20% was still a historical one. The previous record was on January 17, 1991, when the collapse reached almost 35%.

If we consider that the oil and gas sector accounts for about 80% of Saudi Arabia’s exports and 2/3 of the state budget revenues, it becomes clear that the country's economy could seriously suffer if oil prices did not recover. Experts stick to the same opinion. Abu Dhabi Commercial Bank estimates that if Brent oil prices remain at around $35 per barrel, Saudi Arabia will face a deficit of about 15% of GDP in 2020 without adjusting costs and its net foreign exchange reserves could run out in about five years without other sources.

According to estimates by Goldman Sachs Group Inc., the Saudi budget deficit this year could reach almost 12%, and the government’s need for financing will increase by $36 billion per year.

Nevertheless, it is obvious that Saudi Arabia will have to face the new realities and continue the struggle for market share and for buyers. It has already ordered the increase in Saudi Aramco's production capacities from 12 to 13 million bpd. This will allow the company to produce more oil, and taking into account its low cost, make profits even at low prices. Saudi Arabia, by the way, has a very low production cost - $10 per barrel. At the same time, the price at which the budget is balanced is almost twice as high as that of Russia - about $80 against $42.4 per barrel.

BNP Paribas experts have compared the actions of Saudi Arabia with a poker game with Russia, "in which Riyadh raises the stakes", forcing Moscow to eventually return to the negotiating table. The Russian side acknowledged the rules of the game in individual manner, saying that Saudi Arabia did not make the right choice.

By the way, the "production growth" syndrome was contagious. After Saudi Arabia, the UAE and Iraq also decided to lower oil prices for consumers in April and increase exports.

"We're ready to fight!"

Russia’s withdrawal from the OPEC+ deal caused a mixed reaction. According to the supporters of the decision, the move was quite reasonable, since by reducing production volumes, Russia actually encourages the access of American shale oil producers to the world market.

For the opponents of the withdrawal, Russia may lose quite a tangible amount of profits due to a sharp decline in oil prices.

LUKOil President Vahid Alekberov believes that OPEC+ members will find a way to solve the problem at the meeting of the Technical Committee on March 18. The co-owner of the company, Leonid Fedun, believes that as a result of a failed deal between Russia and OPEC to limit oil production, the country will lose at least $100 million daily.

Meanwhile, Russian Finance Minister, Anton Siluanov, stated that Russia is better prepared to the collapse of prices in the global oil market than other large income generating countries. According to Siluanov, Russia "has enough resources to implement all plans for the budget policy."

Russian Minister of Energy, however, declares the possibility of Russian companies in the short term to increase oil production by 200-300 thousand bpd, and in the future - up to 500 thousand bpd. According to A. Novak, the reaction of the market to the failure of the OPEC+ deal was expected in Russia. He emphasised that "the scenario for withdrawal from the agreement was ready and the current situation in the oil market was inline with the forecast."

Despite all measures taken to be ready for the negative scenario, Moscow believes there is still an opportunity to discuss the market situation in May-June 2020 during the planned OPEC+ meetings.

Rosneft, which accounts for about 40% of Russian oil production, was a clear opponent of the new deal. Company spokesman Mikhail Leontyev called the alliance with OPEC "masochism", because it encourages American shale oil producers.

According to Leontyev, the deal with OPEC+ was meaningless. The effectiveness of the deal was only psychological. In reality, though, all the volumes of oil retired after each extension of the deal were quickly and completely replaced with the volumes of American shale oil.

Shale is out

At the same time, if the withdrawal of Russia from the OPEC+ deal was designed to undermine the U.S. oil industry, then the trick worked. If oil prices continue to decline, then it is safe to assume that shale oil producers are going to experience difficult times.

"Everyone, including Russia, will suffer," says Björnar Thonhaugen, head of Rystad Energy’s oil market department. "However, the advantage of this decision is that it will hit others, especially the United States."

According to analysts, with such a sharp drop in oil prices, some shale producers will be forced to leave the market and only the most effective companies will remain that can remain competitive at prices of $35-40 per barrel.

"We already see hints from some shale operators that they intend to immediately adjust spending and drilling volumes," the JBC Energy review notes. "This suggests that for American shale oil producers, the current drop in prices will be more painful than expected."

Despite the record price collapse in the world market, the U.S. production will not fall sharply in any case, analysts at Eurasia Group predict. "Most manufacturers hedged their risks when oil prices were high. We believe that the shale oil production will not fall so fast, as Russians expect," Ayham Kamel of the Eurasia Group told the Financial Times.

At the same time, many American producers of shale oil may have problems attracting new financing and refinancing debts.

Unexpected win

While exporting countries with an oil-dependent economy are taking measures to protect themselves from the risks of declining oil prices, there are always those who will take advantage of the situation to replenish their reserves with cheap oil.

Thus, the Chinese authorities are considering the possibility of increasing state oil reserves after the fall in oil prices. Government planners are consulting with government agencies and state oil companies regarding purchases of sharply cheaper oil recently to replenish strategic reserves. There is no final solution yet, however, increasing oil purchases by China may slightly reduce the excess supply in the market and limit the fall in prices, experts say.

The fall in world oil prices opens up new opportunities for Belarus in negotiations with the Russian Federation on the terms of supplies of raw materials to Belarusian refineries. This opinion was expressed by the Belarusian Prime Minister, Sergey Rumas. "Today we have extra chances to agree with Russia, because the existing situation is significantly different from the situation in December or January," S. Rumas said.

Disappointing forecasts

In anticipation of the escalation of war between Saudi Arabia and Russia, analysts lowered oil prices even further. Disagreements "will cause serious problems for prices and revenue for all oil producers," UBS said. The aggressive decline in oil export prices by the Saudis was "more significant than we expected," analysts say.

Bank experts expect that by the end of the first half of the year Brent will cost $30 per barrel against the previously estimated $40, WTI - $28 against $37 per barrel. Forecasts at the end of September were reduced respectively to $37 from $45 and to $35 from $42 per barrel.

Standard Chartered believes that the collapse of the OPEC+ agreement will lead to a "harsh and prolonged price war." Bank experts expect a significant oil surplus in the next four months. Standard Chartered lowered its forecast for the average Brent price in the second quarter to $23 per barrel from $61. At the end of 2020, bank analysts now expect $35 per barrel against the $64 previously anticipated. The forecast for 2021 has been revised to $44 from $67 per barrel.

According to experts, lower oil prices will lead to a decrease in US production and support demand in the second half of the year. At the same time, bank experts expect that low prices will again unite OPEC and Russia "with an updated agreement on the limitation of production, which will support oil quotes until the end of 2020."

Citigroup analysts believe that the OPEC+ countries will reach a ceasefire and limit production. According to experts, OPEC+ participants can reduce production even by 1 million bpd in the third quarter.

In a word, the only right solution for restoring stability in the oil market and returning prices to a comfortable level of $55-65 is a cooperation format that has proved its effectiveness over three years.

In addition, the current situation showed that the desired result only through the joint efforts of member and non-member states of OPEC, as the cartel alone can no longer cope with it.