- The conclusion we reached over the weekend is that this price war will only last 3-6 months.
- Any duration past 6 months will result in such a severe drop in US oil production, that the decline overwhelms the OPEC+ production increase.
- With Brent now trading at $33/bbl, Russian crude is now selling for $24/bbl as Saudi's OSP cut was designed to destroy Urals pricing.
- Rosneft's breakeven is around $50/bbl Urals, so by June, it would've taken a bloodbath of $10 billion in 3 months. If it lasts into the end of the year, it will have lost half its market cap to this price war.
- At the moment, we would assess the probability of the cuts as follows: End of June price war - 75% probability. Meeting in April - 15%. Meeting in March - 10%.
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Welcome to the price war edition of Oil Markets Daily!
Over the weekend, we published 7 flagship weekly articles. Here are the article titles:
- US Oil Production Sensitivity Analysis To Lower Oil Prices
- Saudi's Strategy And The Thinking Behind The Recent Meeting
- Saudi Price War Scenarios (This article)
- Natural Gas Producers Will Receive The Biggest Benefit From The Latest Oil Market Craze (to be released on HFIR Energy account)
- Global Oil Supply And Demand Under A Price War Scenario Analysis
- The Oil Price War To Our Portfolio - Can CRC And Gear Survive The Carnage?
- What Are We Going To Do With Our Portfolio?
Executive Summary of Our Research
The conclusion we reached over the weekend is that US oil production will fall so fast and hard that, by the end of June, US oil production will be at ~11.75 mb/d. This, combined with the 3-month pain for OPEC+, should bring the end to the price war, but that's not to say things are going to get worse in the short term.
If the price war lasts 6 months, US oil production would fall to ~11 mb/d, or a drop of 1.8 mb/d from the end of 2019. OPEC+ is expected to increase production by ~2 mb/d from current levels, and even in this case, the drop in US oil production will eliminate the increase.
As a result, even if the price war lasts into Q4, the global oil market is headed for an irreversible deficit of ~2+ mb/d as US oil production falls to low ~10 mb/d by the end of the year.
In summary, sub $40/bbl WTI will only be here for 3-6 months.
Saudi Price War Scenarios
There are multiple scenarios we need to discuss here. We will do our best to lay them all out.
But first things first, what is the implication of the Saudi OSP cut to Brent and WTI and to Russian crude pricing.
With Brent trading at $33 today, this means Russian oil companies will be getting $31/bbl.
Source: Giovanni Staunovo
But, as you will see in this image above, Saudi cut the most ever to Europe by a wide margin. In fact, it's the largest OSP cut in history.
At -$10/bbl to Brent, Urals will effectively trade to -$9/bbl (the difference between Urals and Saudi crude). This would immediately put Russian crude at $24/bbl.
The price drop would happen because of the OSP implications. Because the OSP pricing is for April, no physical impact will be dealt to the market, but the pricing pressure would have already taken place.
As a result, here are the scenarios on the table:
Most Painful Outcome - Price War Ends in June
From everything we've heard to date, it does not sound like the Saudis want to prolong this price war past June. The tactic of going to ~11 mb/d in April is meant as a shock and awe strategy that brings all producers back on the table.
And it won't just be the Russians this time, it will also be Kazakhstan, Iraq, Nigeria, and all the other violators of the cut agreement.
Given fiscal breakevens for every country in the OPEC+ group to be above $40 Brent, the longer Brent stays below $40, the more damaging this becomes for the group overall.
A consensus will be reached in June is the most painful outcome from our view.
Least Painful Outcome - Price War Ends Before It Even Starts
This is the lowest possible scenario, but it is one that's been circulated so far today. The pricing mechanism from Aramco (ARMCO) as we laid out above is meant to hurt Russian oil companies the hardest.
In fact, if you do the calculation on the benefits to European refineries, Saudi's OSP is basically the equivalent of a $9/bbl handout to all European refineries. If Russian oil companies do not match Saudi's pricing, no one would buy Russian crude, which would significantly impact the economy further.
After the OPEC+ meeting and after the OSP announcement, Russian executives have already started to express their disdain for how the government handled the meeting. Lukoil (OTC:LUKOY), the second-largest oil producer in Russia, has already publicly stated that this was a big mistake on the part of the Russian government.
According to our knowledge, everyone is supportive of the OPEC+ cut with Rosneft (OTC:RNFTF) holding out even to today. Given that it accounts for ~40% of Russia's oil production and has a direct link to the Russian government, it too will be very vulnerable to the devastation that's about to come.
According to Rosneft's 2019 results, Urals averaged $63/bbl in 2019. At this price, Rosneft's upstream margin average was around ~$13/bbl USD. This puts Rosneft's breakeven around $50/bbl Urals.
Now, if you do the math, Rosneft's liquids production was around ~4.7 mb/d in 2019.
If Urals averages at $26/bbl, the impact to Rosneft would be -$3.384 billion a month. So, if the impact of the price war lasts into June, it would be a total loss of ~$10 billion.
Rosneft has a market cap of ~$65 billion. This would equate to a loss of 16.3% of its market value, and the losses would be permanent as Rosneft would have to sell oil below its marginal cost.
If Brent falls to $35/bbl, Rosneft would have to shut-in production as it would not be able to sell oil at $26/bbl. It would be better to just hold it in storage until better days come.
The only way we see Rosneft not taking this direct hit would be if Putin relaxes on the export customs duty or else the impact would be immediate and swift.
Now, logically, you would think the Russians would be willing to negotiate right away, but given Putin's power stance in negotiations, it is likely that they hold out.
If so, we would see devastating impacts on Russia's economy in Q2 and its oil producers.
Medium Pain Outcome - New Meeting in April
With the damage being done for April already because of the OSP announcement, there's a good possibility that OPEC+ brings forward the May JMMC meeting into April to discuss whether or not the group should bring back the focus on the production cut.
In order for an April meeting to be successful, Barkindo will likely need to visit Russia beforehand to broker an informal deal, so that the Saudis and Russians can negotiate again.
This is one of the scenarios being discussed, which would only make the physical oil market feel the pain in April.
If, however, there are no subsequent discussions in April, it is unlikely to be done in May as the early June meeting would give the Saudis ample reasons to wait out a few more weeks.
At the moment, we would assess the probability of the cuts as follows:
- End of June price war - 75% probability.
- Meeting in April - 15%.
- Meeting in March - 10%.
We are now entering one of the craziest periods in the energy sector. Valuations have gotten so out of hand that we believe this is the final washout. We are now offering a 2-week free trial and if you wish to read our WCTWs this week, please see here.
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