Oil Market: The Bottom Fell Out — Now What?

By Mark Finley

The price war is on. After Friday’s failed OPEC/non-OPEC summit, Saudi Arabia announced its largest price discount in thirty years, and global crude prices today (Monday) are seeing the biggest absolute price decline since 1991. Brent has fallen by half from its peak near $70 per barrel earlier this year.  

What can we expect to see in the oil market going forward? 

Here are some things to watch for if the market starts to become massively over-supplied…

First, how quickly (and how large) will the increase in production be from OPEC producers (especially Saudi Arabia) and Russia?  (At a time when people are rapidly cutting their forecasts for global oil demand due to the negative economic impacts of the Coronavirus…) Early speculation is that Saudi Arabia may try to boost output by as much as 1 million barrels per day (Mb/d) from current levels of about 9.7 Mb/d, while Russia could increase output by up to 300,000 b/d.  

What to watch:  Official pricing and real-time estimates of production in key countries (potentially to include official statements).  Several trade press outlets provide monthly estimates of OPEC production.

If production ramps up quickly, we should expect to see inventories begin to rise. But it’s important to note that we’re not there yet—at least using the oil industry’s standard source of inventory data!  In today’s monthly oil market report, the IEA says OECD commercial inventories at end-2019 were broadly in line with the 5-year average and well below the 5-year high. But that’s data with a big lag—what’s the current state of affairs? Here in the US, we get weekly US inventory data—and it shows the same thing: commercial inventories are only slightly above the 5-year average and well below the 5-year high. There are indications of emerging oversupply elsewhere: the IEA today said that Chinese inventories rose by about 30 million barrels (or 1 Mb/d) in February as demand collapsed due to the impact of the Coronavirus. 

What to watch:  Official inventory data for most countries comes with a big lag—so watch the US DOE weekly data and other high-frequency sources.  More importantly, but at a cost, satellite services can track real-time data (which can be estimated because storage tanks typically have floating tops), including in countries like China and India that don’t report official data on a timely basis.  

• As global crude inventories swell, refining margins will adjust to provide a greater incentive to turn surplus crude into refined products (since those are stored in separate tanks). What to watch:  Real-time refining margins. For actual inventories, same as for crude—weekly US and other higher-frequency data plus satellite tracking services. 
• As commercial onshore inventories get full, the next inventory coping mechanism would be to convert oil tankers to floating storage tanks. Since that’s a more expensive way to store oil, so far we’re not seeing this happen. The only large-scale floating storage at the moment is held by Iran, which can’t sell its oil due to US sanctions. What to watch:  Forward oil prices will shift to provide a greater financial incentive to store crude oil. Also, tanker rates and satellite services that can tell if tankers are full, and parked (vs going somewhere).
• We may see some opportunistic buying of cheap oil for building strategic storage in places like China, which has happened in some previous price declines. But with the economic damage from Coronavirus, Beijing may not be prepared to jump into a cheap oil market as it has done in the past. What to watch:  This is a tougher nut to crack. China is notoriously opaque on official inventories. We can listen to traders’ buzz and watch satellite services to the extent strategic storage uses conventional storage tanks.  

After inventories fill up, the next coping mechanism is to shut off oil production...but whose? Many observers point to US shale producers…but a US supply reaction would not be the ‘first responder’ in a price war: Oil companies would have to decide not to drill/complete wells, and the impact on production would be at best several months away. Some shale producers may go bankrupt, but their existing wells would typically continue to operate in receivership until they are sold to another company. 

What to watch: The weekly rig/frac count data (which again lags production by several months), and high-frequency US/state production data. Some operators may also decide that a low-price environment is a good time to do maintenance—for example, we have in the past seen production fluctuate due to summer maintenance in places like the North Sea, Gulf of Mexico, and Alaska. 

• Demand of course will also be impacted by lower prices, but short-term price elasticity of oil demand is notoriously low. Simply put, it takes time to turn over the vehicle fleet, etc. What to watch: Weekly US and other high-frequency demand data, as well as miles traveled. 

If the market is massively over-supplied, there won’t be time to wait for the shale response. Instead, the candidate for fast reduction in supply is the producer with the highest operating cost. Econ 101 says that existing wells will produce as long as they can cover their operating (marginal) costs. What to watch:  US stripper wells (wells with marginal production) and Canadian oilsands are typically thought to have the highest operating costs among global supply, but we didn’t see material shut-ins of existing production from these sources during the last price war, suggesting these operators didn’t reach their shut-in threshold in 2015. Note also that oilsands operators may operate temporarily with negative margins because they don’t want to lose heat in their production reservoirs, which takes time to build up before production could be (re)started. 

• We may see some high-cost US shale operators reach this threshold (though again, we didn’t during the last price war). Moreover, we could see shut-ins of associated liquids from natural gas wells, which are already under pressure from very low natural gas prices and may shut-in as well.

Wildcards:

• During the last price war, OPEC members were surprised by the resilience of US shale producers, and eventually chose to cut their own production instead. This time around, many observers expect US producers to be under greater pressure from investors/lenders. Moreover, can the industry continue to realize massive productivity gains, which were key to their resilience in the last price war? 
• Can OPEC producers manage their own economies and government budgets in the face of sharply lower oil prices? Given the likely drop in prices, revenues are likely to fall sharply even for producers who do have the capacity to raise production. Can foreign reserves and budget deficits cover short-term spending needs? What scope is there for depreciating currency? How will populations response to belt-tightening? 
• US response: Will the US seek to protect domestic producers? The administration is already talking about policy support for other industries adversely impacted by the Coronavirus.  

It’s a time of massive uncertainty. But hopefully a review of the historical landscape can give us clues of things to watch as the price war unfolds. 

Mark Finley is a fellow in Energy and Global Oil at Rice University's Baker Institute for Public Policy. Before joining the Baker Institute, Finley was the senior U.S. economist at BP. For 12 years, he led the production of the BP Statistical Review of World Energy, the world’s longest-running compilation of objective global energy data.