Oil Has Limited Downside From Here Even Though Math For A Cut Never Added Up

Summary

• OPEC and allies failed to agree to output cuts in March.
• The math for additional curtailments never really added up in the first place.
• Economic ramifications of Saudi Arabia’s unilateral cuts are becoming more painful.
• Q2 2020 glut could be in the 2.0-2.5 million b/d range.
• Limited downside in oil from here as demand side concerns are exaggerated and we expect the price war to be short-lived.

In line with our prediction, OPEC and allies failed to agree in March

As we had predicted on February 24, 2020, OPEC Cannot And Will Not Cut Production In March, OPEC+ failed to agree to a cut in their meetings on March 5 and 6. OPEC had proposed or attempted to impose a 1.5 million b/d additional production curtailment. Notwithstanding, Russia refused to agree to deeper cuts. The proposal had envisaged OPEC members cutting 1 million b/d with non-OPEC producers slashing by 500,000 b/d. Prior to the meeting, there was undue excitement among the analyst community with the market hoping for a cut ranging from 600,000 b/d to 1.5 million b/d.

The math for additional cuts never really added up in the first place

We were skeptical of this from the beginning. And that is because the math for additional cuts never really added up. We believe that in order to gauge a producer’s willingness, capacity and room to make additional cuts, we need to consider two things. The first is to check compliance with their existing quotas and the second is to see where production is from a historical perspective. Except for Saudi Arabia, Kuwait, UAE, Angola and a few smaller players, most of the countries (including Russia) did not meet i.e. exceeded their output quotas for most of the months since 2H 2019. Chart 1 shows this for January 2020. The reluctance to comply stems from the fact that production levels for most of the countries (both OPEC and non-OPEC) are already significantly low from a historical perspective. Exceptions are Russia, Iraq, Kuwait and UAE. Since end-2018, OPEC has been lowering quotas through various means including setting reference levels and encouraging members to adhere to “voluntary” (read lower) production levels. Chart 1 compares individual January 2020 outputs with the peak production levels of all OPEC+ countries. To compare historical production, we believe that 2014 is the pertinent reference point and not 2008. This is because during this time period there has been a dramatic shift in the global oil supply structure on the back of US shale, major upward swing in the budgetary spending of Middle Eastern oil dependent economies and most importantly world crude demand has grown steadily. In the backdrop of all of this, it was always going to be an uphill task to convince countries to make additional cuts.

What really happened inside the OPEC+ meeting…

Let’s talk about this in detail and imagine how the March OPEC+ meeting may have unfolded. Algeria and Angola are staunch Saudi allies but do not have much room to cut further. Congo, Equatorial Guinea and Gabon are too small to make a difference. Iraq and Nigeria were barely adhering to their quotas and especially in Iraq’s case we have been hearing of disagreements on quota levels. Moving on, we really do not see much room for cuts by Azerbaijan, Kazakhstan, Malaysia and Oman. And Bahrain, Brunei, South Sudan and Sudan are also small. Mexico, instead of fall, we see upside risk on potential for fixation of industry-specific indigenous factors, following a long period of sustained declines. Therefore, it all rested on just four players i.e. Kuwait, UAE, Russia and of course, Saudi Arabia.

In Chart 2, we show the hypothetical math that would have been necessary to make possible a 1.5 million output cut. Kuwait’s lowest production since 2014 was at 2,638 kb/d. Being a prime Saudi ally, it could have agreed to a 115 kb/d cut to 2,550 kb/d. UAE’s current production is a little over 335 kb/d from its low, allowing it to agree to a 200 kb/d cut to 2,834 kb/d. Russia’s current crude production is just 2% or about 250 kb/d lower from peak level. This does not portray much of a decline. Well one could say that it has supported the OPEC+ alliance by not boosting production over the years. Recently, Russia managed to exclude condensates from its quota, which worked in its favor. Theoretically speaking, the maximum that Russia could have agreed to a cut would have been 270 kb/d to an ultimate bottom of 10.12 million b/d. There is no way that Russia would ever agree to a cut below this. Not because of budgetary considerations. Nonetheless, because 10 million b/d crude oil production is a strategic double-digit level that Russia would aim to maintain at all costs, especially considering that its cold war rival, US is already nearly approaching the 12 million b/d level. We will talk about the reasons that Russia did not agree to any cuts at all in a while. Thus, considering all the above individual country circumstances, the prospects of a proportional cut across the group never stood a real chance. The only way that a 1.5 million b/d cut could have been achieved was if Saudi Arabia had agreed to slash production by another 700 kb/d to around 9 million b/d. And this assumes that all countries at least adhered to their December 2009 quotas.

Additional unilateral cuts by Saudi Arabia is no longer an option

From 11 million b/d in November 2018, Saudi crude production is already down 1.3 million b/d. Besides, the Kingdom is already producing over 400 kb/d lower than its quota i.e. bearing the burden of the existing curtailments. Honestly, we think that if Saudi Arabia could have carried on with incremental unilateral cuts, it would have done so. However, the economic ramifications are much more painful this time around. The 2020 Saudi Arabia even now projects USD 50 billion fiscal deficit assuming oil production at 9.8 million b/d and average Brent crude of $60. Now with oil sharply below this threshold, you can easily see the Saudi insistence for proportionate cuts. In this context, with Saudi Arabia not willing to cut too much alone, it just did not make sense for Russia to cut anything additional on the back of two major risks. The first is production upside within OPEC itself coming from Libya, Iran and Venezuela. These countries have been exempted from the output restrictions from the start. With their current production remarkably low from all perspectives and arguably at troughs, there are serious upside production risks from each of them. Cumulatively, the output of these countries can quickly recover by anywhere between 0.5-1.5 million b/d. The second risk is that, despite slowing down, the posture of US oil production is healthy along with a huge pileup of DUCs. Therefore, Russia and the broader OPEC+ do not want to lose any more market share.

Demand side concerns seem to be exaggerated and we expect the price war to be short-lived

We think the concerns on the demand side are exaggerated. On coronavirus, there continues to be heightened speculation on the impact on global oil demand. In the beginning of the year, prior to all this, consensus oil demand growth expectations for 2020 was in the 1.0-1.2 million b/d range. The situation remains very fluid with agreement building up that there will be zero demand growth or flat demand this year. Some people are even talking about YoY demand decline. We think that it is very easy to go overboard, and it is premature to go to such extremes. Remember that in Q1 2020 Chinese crude throughputs were down 1.1 million b/d and anticipated to contract by 0.5 million b/d YoY. In line with that, during February, IEA and EIA had razed global oil demand growth expectations by around 300-400 kb/d. In our opinion, another downward revision of 200-300 kb/d is likely this month bringing the total demand impact to at worse 700 kb/d.

We now know what it would take if the unlikely call for additional cuts again comes up. Given that there was no headway towards proportional cuts amidst Russia’s deterrence, this was the only way that the March 5/6 talks could have ended in order to provide political face-saving to the primary OPEC players. Following that on Saturday, in not an unexpected move, Saudi Aramco announced that it was slashing most official prices by $6-8 per barrel across all regions. This signals Saudi Arabia's intention to increase production and begin a so-called "price war". An OPEC+ supply shock could be anywhere between 400,000 to 900,000 b/d. However, we believe that this is just a short-term ploy. In all probability, an understanding of some sort will be reached soon. In fact, the OPEC+ Joint Technical Committee is scheduled to meet on March 18 to review the oil market and price situation. Once the production floodgates open and prices weaken further, sanity will surely prevail because of two reasons. Firstly, because OPEC+ producers are accustomed to making the existing level of cuts as they have been doing it for a while i.e. over a year now. In other words, they can live with that. Secondly, from an oil revenue perspective, it will be counterproductive to produce more in the prevailing weak demand and price environment. Thus, after the initial knee-jerk reaction, we think that production of OPEC+ will come down back to the January 2020 levels. Ironically, this is what the Russian proposal had been all along coming to these talks.

Q2 2020 glut of 2.0-2.5 million b/d seems to be largely priced in

Based on our analysis, we are talking about Q2 2020 oversupply to be in the 2.0-2.5 million b/d range. Chart 3 shows the mid-level OPEC+ probable supply increase and a 700,000 b/d coronavirus impact. What does this mean for oil prices? Take the example of Q2 2015 and Q4 2015 wherein the supply glut was at 2.0 and 2.2 million b/d respectively. This had plunged Brent crude to momentarily below the $30 level. We reiterate that the price war will be short-lived and the market will soon rationalize (i.e.) its demand-side woes from the current doomsday scenario. With Brent already crashing to $30-35 on early Monday, we see limited downside from here.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.