Is the Oil Market Crisis Over? Not at All.
April 3, 2020
Yesterday, President Trump announced via tweet his expectation for Saudi Arabia and Russia to come to agreement over an oil supply cut on the order of 10-15 million barrels (presumably per day, but the president did not specify). The administration also announced its intention to lease 30 million barrels of the U.S. Strategic Petroleum Reserve (SPR) to private companies looking for additional storage for their crude. It could make another 47 million barrels of storage capacity available thereafter. Today, President Trump is expected to meet with several oil and gas company executives to discuss the impact of the coronavirus-induced economic downturn on the U.S. oil industry. On the news of the possible supply deal, the price of oil rose 35 percent. These developments, however, barely make a dent in the economic headwinds facing the industry. By no means is the oil market crisis for the industry over.
Q1: Why have oil prices been dropping, and why do analysts think it will continue to drop?
A1: Since the onset of the Covid-19 outbreak in China, oil prices have deteriorated at a persistent clip. When the crisis started, the expectation was that the global economy would absorb a sizable, but temporary, loss in oil demand resulting from the virus mitigation efforts in China. It was not expected to yield a year-on-year decrease in demand and was widely analogized to the SARS crisis in 2003—a regionally isolated, temporary crisis. This was the context in which the Organization of the Petroleum Exporting Countries-plus (OPEC+) met to decide the fate of the oil supply arrangement that was keeping 2.1 million barrels per day of oil off the market. Saudi Arabia and other traditional OPEC countries tried to corner a reluctant Russia into taking part in a 1.5 million barrel per day cut on top of the existing cuts. Russia refused those cuts and walked away, leaving the agreement to fall apart. In response, Saudi Arabia announced an increase in production from 9.7 million barrels per day to 12.3 million barrels per day and cut their official selling prices. Oil prices immediately collapsed to the $30 per barrel range.
Shortly thereafter, as the virus spread throughout Europe and into the United States, the world realized that keeping Covid-19 at bay meant shutting down global travel and introducing stay-at-home orders across many of the world’s major economies. The realization quickly set in that global oil demand would decline for the year, something that had not occurred since 2008. Things quickly got worse, as the full extent of the oil demand destruction in the short term came into clearer view. Estimates suggest that as of today, global oil demand is down 10 million barrels per day (out of a 100 million barrel per day market), and in the coming week, oil demand could decline by as much as 30 million barrels per day. This drop is unprecedented and will wreak havoc through the sector.
One major factor here is that without major production cuts oil is quickly filling up the world’s storage tanks—public and private—and filling up boats, barges, and trains as well. In some markets, oil producers are paying storage companies to take their crude, leading to a negative oil price dynamic (producers do this because the cost of paying someone to take the crude is less than the cost of shutting in production). Once storage capacity fills up, producers will have no choice but to cut production. In this market, oil prices will continue to collapse until something is done to eat away at both the extra stockpile generated and production still making it onto the market.
Q2: What did President Trump mean about the prospect of an end to the oil price war?
A2: Almost as soon as President Trump tweeted his expectation that Russia and Saudi Arabia would be “cutting back approximately 10 million barrels, and maybe substantially more,” oil prices jumped between 25 and 30 percent for West Texas Intermediate and Brent crude oil, respectively, and prices continued to go up when markets opened on the morning of April 3. For context, these prices are still below what many producers around the world need to keep producing or to meet their budget needs. Counternarratives from Russia and Saudi Arabia began to emerge almost as quickly. For its part, press reports indicate Russia has no idea what this announcement is about and has neither agreed to cut production nor even had a high-level chat with the Saudis about it. The Saudi government released a very muted statement calling for an emergency meeting of OPEC+ and other countries to find a “fair agreement” that will restore balance to the oil markets. Saudi Arabia’s oil production could reach 12.3 million barrels of oil per day this month (with 300,000 barrels coming from storage) while Russian production hovers around 11 million barrels per day. It is somewhat inconceivable that those two countries alone would voluntarily cut 10 million barrels per day without concessions from other countries—particularly the United States, who Russia regards as a free-rider on OPEC+’s efforts to establish oil market stability. But these are not ordinary times. In ordinary times, the most newsworthy part of this day would be the president of the United States announcing an eye-popping cut in production from two of the world’s major suppliers without that agreement being reached.
In today’s world, at this rate of oil demand destruction, two things are nearly certain. First, an oil supply reduction, even of this magnitude, may not be enough to significantly bolster prices in the near term, given the ongoing lockdown of the world’s major economies—although the immediate price impact has been significant. Second, whether the world’s major oil producers agree to a supply cut or not, the market will shut some of their production down anyway.
Saudi Arabia has subsequently called for an emergency OPEC+ meeting on Monday, April 6, and will invite other non-OPEC+ producers to attend (the meeting is virtual). It is not immediately clear who, if anyone, from the United States might attend, but Texas Railroad Commissioner Ryan Sitton has already been quite vocal about his desire to work with OPEC+ on some sort of supply arrangement.
Q3: What is the oil industry asking of President Trump?
A3: Contrary to many popular perceptions of the oil and gas industry, it is not a monolith. One of the strengths of the U.S. oil and gas industry is the sheer number and variety of companies that participate in the oil supply value chain. In the context of the U.S. tight oil revolution, this variety, along with distributed private mineral rights and plenty of private capital, is one of the reasons the United States has achieved an unprecedented surge in oil and gas production. When it comes to negotiating a common approach to public policy and regulation, however, the heterogeneity of the industry presents a number of obstacles. Big producers have heretofore been reluctant to see much government intervention in the market. A letter from the industry’s two largest trade associations makes clear they do not support proposed measures to curtail U.S. production or restrict imports through tariffs or quotas.
Some mid-size producers have a different view, with some advocating for import restrictions, trade measures against OPEC, and organized production curtailment in major producing regions like Texas. The Texas Railroad Commission, the oil and gas regulator in Texas, has agreed to hold a hearing on April 14 to discuss the idea of organized pro-rationing in the state of Texas, and one of three commissioners has been outspoken in his support for the idea of curtailing Texas production and offering that curtailment as a gesture to create a grand bargain supply cut arrangement in OPEC. Many other producers are deeply opposed to this approach for both free-market, ideological reasons and because it would distort a “culling of the herd” that many in the industry thought was long overdue in the first place. The largest U.S. producers are better positioned financially and could see some benefits in this kind of market shakeout.
There are some things industry broadly agrees about. The first is that the administration should pursue diplomatic measures to get OPEC+ producers to stop increasing production—though the ideas about how to do this vary widely, and there is a great deal of pushback to the idea that the United States would have to, in some way, coordinate with OPEC+ on a supply cut to achieve that goal. The second is to relax regulations that might alleviate some burdens for the industry, such as waiving the summer gasoline environmental standards. Even this is not a universally supported option: many producers who want to maintain a record of good environmental performance feel conflicted about supporting regulatory rollbacks from an administration with a track record of being overly aggressive about its deregulatory agenda. Finally, everyone agrees that purchasing 77 million barrels of crude is both marginally helpful and good for longer-term energy security. Congress did not provide the Department of Energy with the funds to purchase this crude oil in the stimulus, so the Department has announced it will allow companies to lease space in the SPR. This measure matters very little in the overall context of the oil market downturn, but it could be meaningful to companies needing to offload production.
Despite President Trump’s early indications that he thought cheap oil was good for the economy, it seems that he is now more sympathetic to the damage being done to the oil and gas sector. That being said, there’s very little the administration can do to help the industry at this juncture, and most of the options they have come with negative tradeoffs.
Q4: What does all this mean for the future of the U.S. oil and gas sector?
A4: In many ways, the U.S. oil and gas industry faces a familiar plight to many other sectors harmed by the economic downturn. Lots of companies are likely to close, lots of capacity will be lost, and none of that is likely to change until some semblance of normalcy is on the horizon. Congress has already grappled with some of what can be done to help the industry—namely offering loan support for private sector applicants, direct support for workers who qualify, and support for states, which could include those where the oil and gas industry is important. None of these measures specifically address the oil and gas industry, however.
Over the longer run, the important strategic question is how much damage will be done to U.S. and global production capacity and will whatever oil production capacity is left (plus storage levels that will need to be worked down) be enough to match oil demand. After years of oversupplied markets and lower oil prices, it is hard to think of a scenario where oil prices spike due to lack of production—especially for those who believe U.S. tight oil provide the ultimate safety valve for price spikes because of its short-cycle production time frames (i.e., U.S. tight oil supply can come on to the market within a matter of six months rather than the five to seven years required for many offshore projects). This belief will only hold true if private tight oil operators still find it in their interest to operate on that basis and if private equity (for many of the small players) still find it attractive to invest in U.S. onshore oil and gas production. Even before this latest crash, capital availability for the U.S. shale patch was much diminished due to years of negative free cash flow for many companies in the sector. Following the Covid-19 crisis, it seems likely that investors will be even more wary. It is possible that at some point underinvestment will lead to problems when the crisis subsides, and demand will pick up again. But that seems like a distant prospect for now.
On the other hand, proponents of a transition away from oil and gas may find the prospect of gutting nearly one-third of global demand to be an opportunity to jumpstart the energy transition. This is only true if whatever is supposed to replace oil is ready in ample volumes to take over that role. While the crisis is affecting the renewable energy industry much less than it is the oil and gas industry, it could also suffer more serious setbacks during a protracted economic downturn. In either situation, failure to provide adequate supply could potentially harm an economic recovery. Lawmakers would do well to go back to the basics and think about what strategic imperatives they are trying to protect—energy security, affordability, and the administration’s blind spot, climate change. On the last issue, hopefully investors and forward-leaning companies will insist that attention to the energy transition is even more important post-Covid-19 than it was before, and maybe Congress will pass an eventual infrastructure or stimulus bill tilted toward the energy transition. Energy security is more difficult. After feeling oversupplied for so long it will be strange to see a market unable to provide enough supply to meet demand. What critical assets should be protected along these lines? How do we keep the labor force robust and healthy enough to work and maintain critical infrastructure? What assets or portion of a project need to be protected and prioritized?
There will be many twists and turns in the oil market saga over the coming weeks and months, and it will make for great intrigue until everyone starts getting fed up with the discussion. But for now, no durable end in sight.
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 (CSIS) in Washington, D.C. Ben Cahill is a senior fellow of the CSIS Energy Security and Climate Change Program.
Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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