Oil Markets on a Free Fall

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Oil posted biggest one-day decline since the Persian Gulf War (1990-1991), since after failing to strike the deal with Russia, Saudi Arabia has actually declared a price war slashing prices for European consumers and threatening to raise production and release more pent-up oil supplies to the market. Thanks to huge spare capacity the kingdom can immediately increase exports by 300K barrels and gradually ramp up supply by an additional 2 million barrels /day, up to 12 million barrels.

Last week, we learned that OPEC and Russia not only failed to agree on deeper cuts above existing OPEC+ quotas, but even couldn’t agree to extend the existing pact, which expires in April. Add to this the strong shock in energy demand as a result of the Covid-19 outbreak and you get the formula for a “free fall” in the oil market.

During the two trading days, Friday and Monday, prices fell 40%.

Goldman Sachs believes that the price of Brent will hang around the $ 30 mark in the second and third quarter. This is a feasible scenario as the worst-case outcome of the last OPEC meeting (ditching existing output curbs) actually meant that everyone is now on his own. Actually, in this situation, whoever starts the offensive earlier will get more profit what Saudi Arabia is actually trying to do. In my opinion, the intention of Saudi Arabia to intimidate or bring Russia back to negotiating table by declaring the price war won’t develop into serios market narrative, since Russia has already made it clear that deeper output cuts yield zero impact on world supply as the past example showed that the US shale firms were pretty quick to make up for OPEC’s output concessions. The short-term benefit of price stabilization (i.e. improvement of market sentiments) is now clearly not in Russia’s interests which should be understood by Saudi Arabia. With armistice in the market abruptly turning into the full-fledged war, markets attention is expected to predictably shift to the “good old” data on bankruptcies of oil shale firms, asset sales and changes in liabilities (proxies of sustainability of the sector), weekly reports on commercial reserves from API, EIA, and changes in drilling activity (Baker Hughes Rig Count). This data lacked relevance for some time because of relative equilibrium on the supply side of the market.

US producers probably hedged their production at higher prices, so the price decline won’t lead to immediate decline in US oil output. After price retracement, resumption of decline will depend on the news how quickly Saudi Arabia starts to execute threats i.e. ramp up production. An increase in leverage among US E&P companies with a general decrease in funding since 2015 speaks in favor of stronger impact of lower prices on the US shale sector:


Source: FT.com

The cost of new financing is rising, which is now intensified by the “flight to quality”, while servicing debt is becoming more difficult. Low prices need to stay for some time to damage US oil sector to the extent necessary for OPEC and Russia to restore cooperation.

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