Commentary on Political Economy

Tuesday, 14 July 2020

The oil cartel confronts the pandemic dilemma

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When an OPEC+ committee meets this week to decide the near-term future of global oil supply, its members will be confronted with the same kind of dilemma that others face in grappling with the uncertain future created by the coronavirus pandemic.
The pandemic smashed the oil price. Having started the year just under $US70 a barrel it plunged below $US20 a barrel in April as demand was decimated by the virus.
A decision by the cartel and its associates in May to cut production by 9.7 million barrels a day, which saw output in June fall to 86.9 million barrels a day - its lowest level in nearly 30 years - saw the price stabilise and gradually edge up to its current levels of just over $US40 a barrel.
Have we reached peak oil? The risks to the market outlook for oil producers are "almost certainly to the downside", according to the IEA.
Have we reached peak oil? The risks to the market outlook for oil producers are "almost certainly to the downside", according to the IEA.CREDIT:WARREN HACKSHALL
The agreement to curb supply envisaged the cuts remaining in place until the end of this month, before reducing to 7.7 million barrels a day from August and being reviewed again in December.
With the coronavirus again spreading rapidly in the US after many of its states tried, prematurely it seems, to resume business and life as normal, the meeting of OPEC+’s monitoring committee that starts on Wednesday is faced with a tricky decision.
Do they press ahead with the original plan or maintain the existing cuts? If they make the wrong call, they might face a fresh fall in oil prices that would produce another hit to oil-dependent economies and another wave of instability for an already destabilised industry.

Massive inventories

The decision is complicated by the scale of the inventories overhanging the market.
The International Energy Agency’s most recent report on the market, issued last week, said OECD stocks rose by 81.7 million barrels in May to 3216 million barrels and that preliminary data from the US showed further increases. On some estimates, stocks grew by nearly two million barrels a day in the June quarter, the biggest rate of increase since the data was first collected in the mid 1950s.
The OPEC+ cuts appear to have brought supply and demand roughly into balance around the 87 million barrels a day level but, even if that were sustained – and it wouldn’t if the spread of the pandemic continues to depress demand or supply is increased prematurely – it could take several years to restore stocks to more normal levels.
In the meantime, those inventory levels will overhang and keep a lid on the oil price.
The US industry is arguably worse off than the global market. Late last year, with production of about 13 million barrels a day, the US became a net exporter of oil for the first time in its history.
That didn’t last long. Output from the US onshore oil sector has fallen about two million barrels a day as the US domestic price, the West Texas Intermediate price, tumbled from more than $US60 a barrel at the start of the year to less than $US20 a barrel in April and May before recovering to just under $US40 a barrel.
There was a moment in May where the WTI price actually fell to minus $US37.63 a barrel as commodity traders effectively paid to have oil taken off their hands rather than accept physical delivery and confront the challenge of dealing with the oil, while US storage facilities were close to capacity.

Bankruptcies, abandoned wells

The plunge in the price has been wreaking havoc in the onshore oil sector, with many of the independent operators highly-leveraged. There has been a spate of bankruptcies and a lot of wells have been shut in or abandoned. The current price is, at best, break-even for most of the producers.
The spread of the virus within the States, the likelihood of new lockdowns, the continuing lockdowns on cross-border travel and the fact that some of the key oil-producing states, like Texas, are being hit hard by rising infection rates adds to the threatening question marks the US oil industry is facing. US inventories have remained at elevated level even as the country's output has tumbled.
The stabilisation of the Brent crude price – the global benchmark – around the $US40 a barrel level has come despite the unusual over-performance of the OPEC+ members, most notably Saudi Arabia, against their commitments to the supply constraints. Compliance with the agreement was 108 per cent. Normally, overall compliance falls short of the commitments.
The IEA, while inserting a qualification related to the spread of the virus through the Americas, envisages some improvement in the industry’s position in the second half of this year.
In the first half, demand fell by nearly 11 million barrels a day, including a 16.4 million barrels a day decline in the second quarter. The IEA thinks the full-year outcome is for an overall 7.9 million barrels a day fall in demand relative to 2019 before some growth adds about 5.3 million barrels a day to demand in 2021.
It believes, if the OPEC+ cuts are tapered as envisaged, global supply would be about 7.1 million barrels a day lower this year than in 2019, with a recovery of that lost production of only 1.7 million barrels a day in 2021.
That outlook of continuing supply-side restraint and modest increases in demand through the rest of this and in 2021 is if all goes well.
That suggests a gradual return to something akin to a pre-pandemic life, particularly in the US, that is already being threatened by the outbreaks in the US and, as Victorians know all too well, elsewhere.
As the IEA said, the risks to the market outlook are “almost certainly to the downside”. For a sector that is already pondering whether the pandemic and the changes to the way businesses and individuals work and live has brought forward the moment of “peak oil,” that’s sobering, even chilling.
It isn’t, of course, the only sector within the global economy trying to predict the unpredictable course of the pandemic and wondering whether it will create permanent changes to the way they operate in the future.

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