The failure of the Opec+ coalition, which includes Russia, to reach an agreement on production cuts on March 6 has sent oil prices into a tailspin, with WTI dropping into the $20s in early trading (and still on course to land in the low $30s). That's the biggest single-day loss in almost 20 years, essentially wiping out all gains since the 2016 low after the shale-driven downturn.
Last week, the prevailing view was that the cartel and its partners, including Russia, would continue to support oil prices as the outlook for demand growth continues to deteriorate – due to the worldwide coronavirus outbreak, and its economic ramifications. Investors were anticipating, at minimum, that Opec+ would agree to extend the current cuts through 2020, instead of letting them expire at the end of March. And the cartel agreed to do so on March 5, while increasing the volumes being withheld from 500 thousand barrels per day to 1.5 million barrels per day (mmbpd).
But the proposal was not binding without co-operation from Opec partners, and on March 6, Russia refused to participate in further cuts. That theoretically frees cartel members from production ceilings, leaving them free to ramp production to capacity and worsen the current supply-demand imbalance. The situation was further exacerbated when Saudi Arabia started selling crude at heavy discounts, essentially igniting a price war and sparking pandemonium in oil markets.
Supply Shock Meets Demand Shock
The resulting supply shock essentially coincides with a demand shock related to the coronavirus, resulting in particularly steep price declines. And we would not rule out further weakening after the dust settles at the end of March 9. So the near-term outlook for energy companies is bleak, and it is likely that many of our fair value estimates will be revised lower as a result. However, these issues only affect cash flows in the next one-to-two years. Russia and Opec lack the capacity to displace US shale producers in the global supply stack, which means the marginal supply cost is still $55 per barrel WTI.
On February 26, we argued that while the market was failing to incorporate the full impact of the coronavirus outbreak, the demand dip in 2020 would be offset by weaker-than-expected shale growth as well as prolonged Opec cuts. But the situation has clearly evolved since then.
Opec producers are now free to unleash their full capacity – there is no incentive for any individual producer to comply with prior ceilings. However, that does not necessarily mean a supply onslaught is coming. For some cartel members, recent production declines were involuntary and no ceilings were in place anyway. For instance, US sanctions have hampered Iranian exports, Venezuela is suffering from chronic mismanagement of its oil industry amid economic turmoil, and Libya has no central government, leaving warring factions to jostle for control of its production.
Similarly, some producers have not invested enough in maintaining production, or are struggling with dwindling reserves. But there are those, like Saudi Arabia and the UAE, that do maintain excess capacity and are likely to ramp volumes this year. These producers demonstrated that capacity by boosting volumes temporarily in the back half of 2018, giving us confidence that they really can increase production. On balance, we now expect an incremental 1 mmbpd of supply from Opec through the end of the year.
Will Glut Turn to Shortage?
Likewise, Russia is not likely to deliver a huge surge in output. It most likely refused to make further cuts last week to avoid indirectly benefiting US shale producers while sacrificing volumes itself (perhaps in retaliation for US sanctions blocking the completion of its Nord Stream 2 Siberia-Germany natural gas pipeline). We expect it to restore the 300 mbpd it gave up upon joining Opec+ at the end of 2016 in relatively short order. However, further growth potential is probably limited. If Russia could systematically undercut US shale producers with meaningful volumes above its current output it would probably have done that already instead of partnering with Opec. Thus, in total we see an additional 1.5 mmbpd of supply finding its way to the market by the end of year from Opec and Russia. That's significant but does not threaten the existence of the 10+ mmbpd US shale industry.
Besides, the near-term collapse in oil prices that we are now witnessing will certainly erode US growth this year, offsetting any excess from Opec+. We now expect under 1 mmbpd growth from the US in 2020, which is half of what it delivered in the prior year. That's not hugely different from our previous forecast, because there are long lags between changes in crude price, rig count, and production levels. However, we are now expecting only 500 mbpd growth from the US in 2021.
So, even if the coronavirus keeps demand flat this year instead of growing by 1.2-1.3 mmbpd as it was previously expected to, we do not see any glut going past 2021. Demand growth tends to be highly elastic with respect to prices, so next year's growth could surpass the recent trend. So it's not unreasonable to assume 1.5 mmbpd cumulative growth in the next two years, even if 2020 growth is extremely weak. And that offsets what we estimated earlier from OPEC+. That still leaves a small surplus for the US growth we currently model, but at only about 500 mbpd this could be soaked up in a number of ways.
Beyond 2021, we would still expect robust demand growth as disruptive factors like electric vehicles will take much longer to meaningfully reduce global crude consumption. Yet US shale would be the cheapest source of incremental supply, and it has a marginal cost of $55/bbl for WTI. Prices must therefore recover to incentivise this expansion, or the glut will flip into a painful shortage.
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