During the past few weeks, the oil market experienced unprecedented volatility. On 20 April, “the Black Monday”, the price of the West Texas Intermediate fluctuated between -40 USD and positive values.
Barrels of ink have been spilled explaining the negative price of the oil barrel. To understand such price, we should consider that during the month of April the oil demand fell by 29 million barrels of oil per day (mb/d). Each day in April, 29 million barrels of oil, almost a third of the global production where not used by consumers. Some USA producers and traders were left with a product that nobody wanted. Oil, which has been for decades the lifeblood of our economy, turned into garbage and the owners of such garbage had to pay someone to get rid it of it.
Will the oil demand go back to the 100 mb/d used in 2019?
The world will never again consume the 100 mb/d used before the arrival of the Covid pandemic. We reached the so-called peak oil demand.
Various reasons will lead to a structural reduction of demand. Teleworking and video conferences will reduce not only commuting but also business flights. Air carriers will retire the older and less efficient aircraft, there will be fewer flights and such flights will consume less fuel. Manufacturing will privilege resilience over efficiency, production chains will be reshored as local production will be preferred. Goods as well as people will travel less. As Bill Gates put it on The Economist: “Airports won’t have crowds, sports will be played in empty stadiums, the economy will be depressed”. Not everybody agrees on a permanent reduction of oil demand but there is a wide consensus that the effects of this pandemic will persist for a while.
Who will be the winners and losers?
When we look at the oil markets, three countries - USA, Russia and Saudi Arabia – stand out, controlling in total a third of the global production. All the other players, although relevant, are far behind.
Kingdom of Saudi Arabia
In early March, when Covid was not yet perceived as so disruptive, Saudi Arabia and Russia started an oil price war, the OPEC+ alliance collapsed and with it the oil price. In the following days, Covid and the related measures of confinement destroyed oil demand and killed a moribund oil price.
In a low-price environment, Saudi Arabia is the weakest of the three main producers. Although its production costs are below 3 USD per barrel, the Kingdom needs around 80 USD for its fiscal breakeven. However, since 2014, the oil price went above the 80 USD band only for a short period in 2018.
In the past six years the country used its foreign reserve assets to balance its budget. In March, reserves fell by almost $24 billion. At this speed of depletion, Saudi’ reserves of 500 billion USD will be vanished in two years.
Moreover, the Kingdom is over-dependent on the petroleum sector which represents 90% of its export earnings.
To make things worse, the Saudi’s currency is pegged to the USD and the Kingdom cannot devaluate it to compensate for low oil price. Unless it restructures drastically its economy, the Kingdom will be the main losers of the low oil price/demand scenario.
The Russian Federation is in a stronger position than Saudi Arabia, as it requires an oil price around 40 USD to balance its budget. The higher prices achieved through the production cuts agreed by the OPEC+ allowed Russia to replenish its reserves which now stands at around 400 billion USD. In March, Russian energy Minister praised the OPEC+ alliance which provided Russia with the resources to withstand an oil price of 25 USD for 10 years.
Another key factor in favour of Russia is its flexible exchange rate. Its oil producers collect money in USD but pay their cost in a devaluated rouble.
Finally, the Russian Federation is less dependent than Saudi Arabia on oil and gas, which represent less than two thirds of its exports. The country also exports other natural resources as coal and uranium and has a strong defence industry whose export is second only to the USA.
The Russian Federation is therefore better equipped than Saudi Arabia to withstand a sustained period of low oil price and demand.
Between 2010 and 2019, through the massive deployment of horizontal drilling and fracking, the USA more than doubled oil production becoming the major world oil producers.
In 2014, when price collapsed, USA shale oil producers managed to reduce their breakeven from 60 to a 40 USD band, trough technology innovation, efficiency and cost control. However, in the current situation, space for further reductions of production cost is limited, shale companies are leaner to the bone and they cannot increase efficiency for ever.
Furthermore, most of the shale companies hold huge debts that they cannot repay as, at current oil price, they are even unable to cover cost. There will be a decimation of these companies and only the most efficient will survive. The other will bankrupt and their assets will be bought by bigger and more resilient companies.
There will be a period of merging and acquisition as at the end of 1990s. At that time, with oil in the 10 USD range, BP bought Amoco, Exxon bough Mobil and Total took over Fina and Elf. The same will happen in the next few months confirming the say that: “When oil prices are down the best place to drill is Wall Street”. It is not incidental that major USA oil companies have not been very vocal in requesting government support. They prefer a “let the market play” attitude as they could buy a shale business on sales.
Will this be bad for the USA economy?
Despite the Trumpian rhetoric about defending indigenous shale oil producers, USA citizens and companies will benefit from a cheaper price of energy. Some jobs will be lost in the oil business but other will be created in other sectors which will benefit from a lower price of energy.
As regards as the claimed energy independence of the USA, although having oil produced domestically could give a sense of security, the fact that a few millions of barrels could be imported will not affect the country energy independence. To a large extent the oil market is global and therefore if the price goes up or down everybody is affected regardless of the amount of their indigenous production.
A geopolitical revolution?
The Covid-19 crisis will reduce permanently our oil consumption, notably in the transport sector, which relies for close to 100% on oil products.
Saudi Arabia and other petrostates with a high fiscal breakeven face the double challenge of reduced demand and low prices. They should therefore accelerate their economic and energy diversification by embarking on the clean energy transition. Alternatively, they could wait to be saved by a higher oil price but, the price recovery, if any, could be too little and too late for them.
Russia is better equipped than petrostates to cope with the challenges of low oil price and demand and could take advantage of the relative weakness of Middle East countries to increase its influence in the region.
USA production cannot be dictated by the president as it is fragmented among hundreds of companies which operate in a free market. Companies with the highest production cost will need to adapt to a new price regime. There will be mergers, acquisitions and bankruptcies but eventually the survivors will be leaner and more efficient. The USA will import more oil and this could lead to a more assertive stance in its foreign policy notably in the Gulf region.
Overall, there will be geopolitical resets, as it happened in the past. After the Second World War, the shift from coal to oil magnified the relevance of Middle Eastern countries. At the beginning of this century, the shale oil revolution turned the USA into the biggest oil producer. We now face a change of a similar magnitude which will reorder the rank of the energy superpowers.
The opinions expressed by the author of this article are personal and do not represent the view of ISPI or other organisations for which the author worked in the past.