Paper barrels are one thing while physical barrels are another.
Global supply shut-ins will happen long before storage levels at consumer nations hit tank top (think US here).
With demand estimated to fall 10 to 20 mb/d in April, refineries already are cutting throughput by 10 mb/d. This, in turn, reduces crude buying by at least 10 mb/d.
As a result, April global crude exports are going to tank, and the Saudis won't even be able to sell any additional oil into this market environment to begin with.
Canada is a great real-time example of this. In April, Canadian oil production will fall ~10% or between 400k to 500k b/d. This is why it's far more likely that shut-ins happen globally at the producer level rather than at tank-top in consumer nations.
During the last two weeks, we've been saying the same thing over and over again. While it's very easy to open Excel, plug in a drop of ~10 mb/d in demand, and assume that's the imbalance, it's harder to try and figure out logistically how this ~10 mb/d of oversupply actually makes it into consumer nations and global storage.
Paper barrels are one thing while physical barrels are another.
This is why we published these three articles over the last week and why it's a good time to revisit them.
The truth of the matter is that we've never had an event like the one we are seeing today. Historically, demand declines have been counterbalanced by Saudi Arabia unilaterally cutting supplies. Why? Because lower demand means lower exports, and so the Saudis are most capable of stemming off any demand decrease.
But given the policy for the Saudis is to pump at free will and the OSP cut has cut deep into distressed barrel territory, the Saudis won't be relinquishing any export declines this time, so instead, it will be other producers that can't match the Saudi OSP cut to take the hit.
And despite Saudi OSP cuts going into the bone, buyers are still refusing extra barrels offered, because if there's no demand for it, no one wants it, period.
So for the month of April, we don't even see an increase in Saudi exports by much. We suspect Aramco (ARMCO) won't even need to go to ~12.3 mb/d in total supplies because exports are likely to remain between ~7 to ~7.5 mb/d. Russian oil producers already have refused to increase oil production into this low pricing environment, so we can expect at least both countries' exports to remain relatively stable.
But in a falling demand environment and a shrinking pie, what will happen is the producers that can't discount the barrels will be forced to store the unsold crude. And because exporting countries typically have very low storage capacity (see Canada, it only has ~40 million barrels of capacity), production shut-in follows.
Implications for the global oil market
This is important to understand here. Because demand is decreasing so severely, refineries globally will cut throughput by the same amount demand decreased. So, for example, if demand declines by ~10 mb/d or ~20 mb/d, refinery run cuts will lag by a week or two to ~10 mb/d first, and then 20 mb/d after.
As refining margins stay more and more depressed, more run cuts will come to stem product storage from building. During the lag phase of the run cut and demand hit, product storages will build. But after the run cut happens, product storage will stabilize. In some extreme cases, product storage at certain regions of the world will hit tank-top, forcing refineries in those regions to go into drastic measures, possibly offering contango spreads so attractive that oil trading firms like Vitol simply can't refuse.
Now for the crude side, as the refineries cut throughput massively, the intake for crude drops by the same proportion. This will then also have a lag effect. For example, refineries cutting throughput now will still receive the crude it bought a month ago. So during this lag period, crude inventories will build, and that's what we saw in global crude storage data in China so far.
But by April, refineries globally will halt crude buying. Instead of looking at the discounts offered, if the product margins continue to get crushed (no reason it won't until demand rebounds), refineries will refuse to buy anything more than the minimum.
This means that by mid April, the level of global crude exports will start to drop to match the level of refinery run cut.
This is an extremely important point to understand because as global crude exports drop, the shut-in will happen at the producer level. So the market, in theory, will never allow consumer nation storage levels to hit tank top. Because if consumer nation storage like the US hit tank top, then all buying in the future will stop, which would then cascade into zero exports down the road. As a result, the mechanism for the market will be to stop the potential of a tank-top by punishing prices for exporting countries to the level of a shut-in.
This, in turn, may cause the drastic contango levels some analysts have said, but it's unlikely crude falls into the single digits even in the near term. This is in part because there are usually clauses in exporting country agreements where pricing can't be negative. So an example is to take the Saudi crude OSP cut of $12/bbl to Brent, if Brent fell to $9 for example, Saudi would be selling it at -$3/bbl. This negative pricing would then eliminate that trade and the export wouldn't be made. Which then stops future supply or effectively a shut-in even for the Saudis.
This is why it's far more likely that shut-ins happen globally at the producer level rather than a tank-top in consumer nations.
Canada is a great real-time example of this. With pipelines flowing directly to the US, if Canadian producers feel the pressure of negative pricing (think rail here), then shut-ins will happen far before the supply makes its way to the US.
We already are seeing widespread shut-in announcements in April, and we expect the total supply reduction from Canada alone in April to total ~10% or around 400k b/d to 500k b/d.
This will be a phenomenon you see happening globally to combat the coronavirus demand destruction.
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 WCTW this week titled "Global Production Shut-In Is Needed To Fight The Coronavirus, Not OPEC+", please see here.
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.