OPEC+ Strikes a Deal, But Big Challenges to Come

After a month of oil market chaos, the Organization of the Petroleum Exporting Countries (OPEC) has agreed on production cuts, but the supply reductions may be too small to place a floor under oil prices. The alliance of producing states known as OPEC+ held an emergency meeting on April 9 and is close to finalizing a coordinated supply cut of 10 million barrels per day. Energy ministers from the G20 countries also held discussions today over the Covid-19 impact on the oil market and the global economy.

The oil market crisis has been deeply destabilizing for governments, companies, and equity markets, and it is reassuring that global institutions are working to address these challenges. Still, even a production cut of this size will not be large enough to offset the Covid-19-induced demand shock, and oil prices could tumble in the coming weeks as inventories rise.

Q1: What Was Included in the OPEC+ Agreement?

A1: Oil ministers convened by videoconference on April 9 to discuss a coordinated production cut. Nearly all of the group has approved a cut of 10 million barrels per day for the months of May and June, with the reductions narrowing to 8 million barrels per day for the rest of 2020. In theory, the cuts will drop to 6 million barrels per day from January 2021 to April 2022. This is an unusually long timeframe for an OPEC production cut, signaling the gravity of the oil market challenges.

Saudi Arabia and Russia are expected to contribute half of the burden, with each cutting from a baseline of 11 million barrels per day to 8.5 million barrels per day. The rest of the producers are expected to provide the other 5 million barrels per day in cuts, based on 23 percent reductions from their October 2018 volumes. (The baseline of cuts is a perennial sticking point in OPEC production targets.)

Mexico added some drama by rejecting its targeted 400,000 barrels per day cut, instead pushing for a 100,000 barrels per day reduction. Marathon negotiations continued into the early hours, and an OPEC statement said the deal was “conditional on the consent of Mexico,” which could come later today. Capping an eventful day for the market, President Donald Trump spoke to both Saudi Arabia’s King Salman and Russian President Vladimir Putin by phone, continuing his push for a resolution to the market standoff.

Q2: What Role Will the G20 Play?

A2: Energy ministers from the G20 are also tackling the oil industry crisis. Today officials from the world’s largest economies discussed how to respond to the oil market volatility and the ripple effects for global trade and investment, not to mention the economic health of major producers. The G20 is not the typical forum for discussing oil market issues, but the International Energy Agency and others urged it to weigh in as both producing and consuming states consider emergency measures.

On the production side, OPEC+ has suggested that non-OPEC states should contribute another 5 million barrels per day in production cuts. Various G20 countries including the United States, Canada, Brazil, and Norway are important industry players and are likely to see big drops in oil production this year. But formalized production cuts from these states were not in the cards, and the notion that Texas would join Saudi Arabia and Russia in a joint effort to manage the oil market was fanciful. Instead the G20 states put forward their own forecasts of market-driven supply cuts. The U.S. Energy Information Administration (EIA), for example, now foresees a drop in U.S. crude oil production to 11.1 million barrels per day in 2021—a drop of some 2 million barrels per day from the recent peak.

On the demand side, the G20 states are coping with unprecedented volatility in oil prices that has spilled over to financial markets. While importers enjoy some short-term benefits from lower oil prices, there is little upside in the face of a synchronized global recession. It is possible that the G20 will pledge to fill strategic petroleum reserves, a move already made by Washington, in an effort to boost demand. Such measures may be well founded but the market impact will be minimal.

Q3: Will the Supply Cuts Work?

A3: Just as nature abhors a vacuum, so does the oil market. The implosion at last month’s OPEC+ meeting cast doubt on its ability to deal with the Covid-19 crisis and play its traditional role in helping to counteract volatility and provide messaging to the market. Already the group was struggling to manage the unpredictable nature of U.S. shale, the oil market impact of sanctions, and fears of looming peak demand amid the energy transition. But in times of crisis, the oil market still needs OPEC, and even critics of the organization—particularly in Washington—have piled on the pressure for the group to retake the helm. Yet again, OPEC has pulled together under duress. The fact that Russia has been brought back into the fold, ensuring the continued viability of OPEC+ for now, is a victory for Saudi Arabia.

Still, few expect a durable rebound in oil prices. The market was not impressed with the 10 million barrels per day targeted cut, with Brent and West Texas Intermediate (WTI) crude down on Thursday’s closing despite news of an impending deal. With many analysts forecasting that demand will plummet by 20 million barrels per day or more in the second quarter, even a cut of this magnitude would mean substantial inventory builds (see discussion below).

April will also be bleak, and the good news of the agreement could be drowned out quickly. Saudi Arabia has already set low official selling prices (OSPs) for April exports and claims it has ramped up output to a record-breaking 12.3 million barrels per day in recent days. Nigeria also cut prices for its key crude grades earlier this month. Saudi Aramco delayed setting its OSPs for May exports until after the OPEC+ meeting, and its counterparts in Abu Dhabi and Kuwait have followed suit, but for April the damage is already done.

Market conditions are evolving more rapidly than political solutions or coordinated supply cuts, and the OPEC+ agreement may be well be a moving target. Economic conditions could require deeper cuts over the coming months, and if the Covid-19 crisis continues to suppress demand, producers could lose faith. More broadly, the production agreement will do little to address the argument that OPEC cuts are aiding non-OPEC producers, especially in the U.S. shale patch. For years, skeptics in the producers’ club have argued that cuts have ceded their market share to non-OPEC players while failing to improve their own economic fortunes.

Ultimately, however, there is no alternative to supply cuts for the entire industry. Most within OPEC prefer an early and coordinated supply response that could reassure the market rather than inevitable piecemeal measures.

Q4: How to Gauge Progress?

A4: Inventories will provide a critical signal. As demand has eroded in the past few months, there have been ample signs of stock builds in crude oil and products around the world, and this process is accelerating. When buyers are scarce, producers either have to send oil to storage or, ultimately, keep it in the ground by cutting back production. With such a depressed demand scenario, there is much speculation in the market about how soon the world will run out of storage.

Citibank estimated in late March that there was 1.7 billion barrels in available commercial and strategic storage, with floating storage (oil stored on tankers) able to accommodate perhaps another 130 million barrels. Storage capacity is an opaque matter, especially outside the Organisation for Economic Co-operation and Development (OECD), but it is clear that with stock builds at this rate, the pressure will build in the months to come. Problems will also become apparent long before storage tanks are full, as storage capacity is distributed unevenly across the world and some areas will see faster builds than others. Many crude grades are also disadvantaged by differentials and transportation costs.

When inventories get out of control, OPEC loses leverage. Beginning in 2016, the organization focused on bringing OECD inventories down to the five-year average, which proved an elusive goal that was eventually adjusted. Those hopes are now a distant memory, and the longer this imbalance continues, the longer it will take to work off the inventory build. OPEC’s hope may be that a severe contraction in investment will lead to an imbalance in the future when the coronavirus crisis subsides and demand picks up again. In the meantime, there is a real risk that ballooning inventories will depress prices.

Ben Cahill is a senior fellow in the Energy Security and Climate Change Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C.

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Ben Cahill
Senior Fellow, Energy Security and Climate Change Program