We are almost a month past the announcement by the OPEC nations that they had informally agreed to a production cut at a meeting in Algiers, and almost a month away from the formal meeting where OPEC will convene to formalise the agreement. And already we are seeing fractures within the coalition, interspaced between some encouraging news.
On one hand, Russia’s Vladimir Putin appeared to back the production freeze at a conference in Istanbul, and Saudi Arabia has recently commented other non-OPEC countries have expressed willingness to negotiate a pan-global production cut. If this happens, markets will rally, crude prices will rise and everyone will be better off all around. Even the small cut of up to 1 mb/d proposed by OPEC had a material effect, offset by prices that breached US$50/b when it was announced. A more significant cut, say to the tune of 3-4 mb/d, would do much to alleviate the global supply glut, benefitting all players in the industry with higher prices.
As wonderful as that sounds, it will not happen. Within OPEC itself, three members states – Iraq, Venezuela and Iran – are already disagreeing on the data the organisation uses to calculate the block’s output. They claim that that discrepancies in individual member output figures distort OPEC’s total monthly production, which in turn will distort the planned cuts, which will be apportioned across all members except for Libya, Nigeria and Iran, which have exemptions. It speaks poorly of the trust the organisation has internally if its own data cannot be trusted, but OPEC is now an organisation glued together by mere vague history instead of a common goal that it had in the 1970s.
Externally, Saudi Arabia might talk big about Russia and other major
producers like Canada, Norway, Brazil and the US joining the freeze, but it is
a pipe dream. These producers might make overtures to support a cut, but unless
a binding agreement is signed, have no responsibility to adhere to any cuts.
And even if binding quotas are agreed on, they can easily be flouted, just like
in OPEC itself.
This is a classic example of game theory at work – the economic
theory that players within the game will tend to look out for their own
interests, instead of the interests of a common group. This is made more
complicated by the fact that there are two sets of games being played – within
OPEC, and between OPEC and non-OPEC countries.
If the OPEC countries could just cooperate, gains would be shared by
all. But there is too much temptation to ‘cheat’ for greater individual gains –
exacerbated by the exemptions for Nigeria, Libya and Iran – thereby causing
losses for all. And even if OPEC could get its own house in order, it is still
in a game with the rest of the world. Russia might say benign words, but would
be more than happy to pump more oil to steal market share from under their
noses. And that’s saying nothing of countries like the USA and Canada, where
free market forces will conspire to raise supply in response to a rise in
prices, thereby pushing prices down again. We have already seen this in the US,
where the number of operating oil and gas rigs has risen to its highest level
in more than a year, adding new rigs 15 out of the last 16 weeks.
OPEC and non-OPEC producers know this, and more importantly, the
market knows this; which is why prices have barely budged from their new level
in the low US$50/b range. Here it will stay, unless by some miracle, all
players in the industry could be brought in line for the benefit of all,
instead of gains of a few. And in the end, this episode of OPEC will be nothing
more than mere sound and fury, signifying nothing.
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Source: U.S. Energy Information Administration, based on Bloomberg L.P. data
Note: All prices except West Texas Intermediate (Cushing) are spot prices.
The New York Mercantile Exchange (NYMEX) front-month futures contract for West Texas Intermediate (WTI), the most heavily used crude oil price benchmark in North America, saw its largest and swiftest decline ever on April 20, 2020, dropping as low as -$40.32 per barrel (b) during intraday trading before closing at -$37.63/b. Prices have since recovered, and even though the market event proved short-lived, the incident is useful for highlighting the interconnectedness of the wider North American crude oil market.
Changes in the NYMEX WTI price can affect other price markers across North America because of physical market linkages such as pipelines—as with the WTI Midland price—or because a specific price is based on a formula—as with the Maya crude oil price. This interconnectedness led other North American crude oil spot price markers to also fall below zero on April 20, including WTI Midland, Mars, West Texas Sour (WTS), and Bakken Clearbrook. However, the usefulness of the NYMEX WTI to crude oil market participants as a reference price is limited by several factors.
Source: U.S. Energy Information Administration
First, NYMEX WTI is geographically specific because it is physically redeemed (or settled) at storage facilities located in Cushing, Oklahoma, and so it is influenced by events that may not reflect the wider market. The April 20 WTI price decline was driven in part by a local deficit of uncommitted crude oil storage capacity in Cushing. Similarly, while the price of the Bakken Guernsey marker declined to -$38.63/b, the price of Louisiana Light Sweet—a chemically comparable crude oil—decreased to $13.37/b.
Second, NYMEX WTI is chemically specific, meaning to be graded as WTI by NYMEX, a crude oil must fall within the acceptable ranges of 12 different physical characteristics such as density, sulfur content, acidity, and purity. NYMEX WTI can therefore be unsuitable as a price for crude oils with characteristics outside these specific ranges.
Finally, NYMEX WTI is time specific. As a futures contract, the price of a NYMEX WTI contract is the price to deliver 1,000 barrels of crude oil within a specific month in the future (typically at least 10 days). The last day of trading for the May 2020 contract, for instance, was April 21, with physical delivery occurring between May 1 and May 31. Some market participants, however, may prefer more immediate delivery than a NYMEX WTI futures contract provides. Consequently, these market participants will instead turn to shorter-term spot price alternatives.
Taken together, these attributes help to explain the variety of prices used in the North American crude oil market. These markers price most of the crude oils commonly used by U.S. buyers and cover a wide geographic area.
Principal contributor: Jesse Barnett
A month ago, the world witnessed something never thought possible – negative oil prices. A perfect storm of events – the Covid-19 lockdowns, the resulting effect on demand, an ongoing oil supply glut, a worrying shortage of storage space and (crucially) the expiry of the NYMEX WTI benchmark contract for May, resulted in US crude oil prices falling as low as -US$37/b. Dragging other North American crude markers like Louisiana Light and Western Canadian Select along with it, the unique situation meant that crude sellers were paying buyers to take the crude off their hands before the May contract expired, or risk being stuck with crude and nowhere to store it. This was seen as an emblem of the dire circumstances the oil industry was in, and although prices did recover to a more normal US$10-15/b level after the benchmark contract switched over to June, there was immense worry that the situation would repeat itself.
Thankfully, it has not.
On May 19, trade in the NYMEX WTI contract for June delivery was retired and ticked over into a new benchmark for July delivery. Instead of a repeat of the meltdown, the WTI contract rose by US$1.53 to reach US$33.49/b, closing the gap with Brent that traded at US$35.75b. In the space of a month, US crude prices essentially swung up by US$70/b. What happened?
The first reason is that the market has learnt its lesson. The meltdown in April came because of an overleveraged market tempted by low crude oil prices in hope of selling those cargoes on later at a profit. That sort of strategic trading works fine in a normal situation, but against an abnormal situation of rapidly-shrinking storage space saw contract holders hold out until the last minute then frantically dumping their contracts to avoid having to take physical delivery. Bruised by this – and probably embarrassed as well – it seems the market has taken precautions to avoid a recurrence. Settling contracts early was one mechanism. Funds and institutions have also reduced their positions, diminishing the amount of contracts that need to be settled. The structural bottleneck that precipitated the crash was largely eliminated.
The second is that the US oil complex has adjusted itself quickly. Some 2 mmb/d of crude production has been (temporarily) idled, reducing supply. The gradual removal of lockdowns in some US states, despite medical advisories, has also recovered some demand. This week, crude draws in Cushing, Oklahoma rose for the second consecutive week, reaching a record figure of 5.6 million barrels. That increase in demand and the parallel easing of constrained storage space meant that last month’s panic was not repeated. The situation is also similar worldwide. With China now almost at full capacity again and lockdowns gradually removed in other parts of the world, the global crude marker Brent also rose to a 2-month high. The new OPEC+ supply deal seems to be working, especially with Saudi Arabia making an additional voluntary cut of 1 mmb/d. The oil world is now moving rapidly towards a new normal.
How long will this last? Assuming that the Covid-19 pandemic is contained by Q3 2020, then oil prices could conceivably return to their previous support level of US$50/b. That is a big assumption, however. The Covid-19 situation is still fragile, with major risks of additional waves. In China and South Korea, where the pandemic had largely been contained, recent detection of isolated new clusters prompted strict localised lockdowns. There is also worry that the US is jumping the gun in easing restrictions. In Russia and Brazil – countries where the advice to enforce strict lockdowns was ignored as early warning signs crept in – the number of cases and deaths is still rising rapidly. Brazil is a particular worry, as President Jair Bolosnaro is a Covid-19 skeptic and is still encouraging normal behaviour in spite of the accelerating health crisis there. On the flip side, crude output may not respond to the increase in demand as easily, as many clusters of Covid-19 outbreaks have been detected in key crude producing facilities worldwide. Despite this, some US shale producers have already restarted their rigs, spurred on by a need to service their high levels of debt. US pipeline giant Energy Transfer LP has already reported that many drillers in the Permian have resumed production, citing prices in the high-US$20/b level as sufficient to cover its costs.
The recovery is ongoing. But what is likely to happen is an erratic recovery, with intermittent bouts of mini-booms and mini-busts. Consultancy IHS Markit Energy Advisory envisions a choppy recovery with ‘stop-and-go rallies’ over 2020 – particularly in the winter flu season – heading towards a normalisation only in 2021. It predicts that the market will only recover to pre-Covid 19 levels in the second half of 2021, and a smooth path towards that only after a vaccine is developed and made available, which will be late 2020 at the earliest. The oil market has moved from certain doom to cautious optimism in the space of a month. But it will take far longer for the entire industry to regain its verve without any caveats.
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