Two months ago, the crude oil market was abuzz with chatter that US$100/b oil was imminent. Fuelled by worries over the impact of American sanctions on Iranian crude exports, industry powerhouses from Glencore to JP Morgan to BP predicted that Brent would hit US$90/b by Christmas, and breach the three digit mark in Q12019. With just over a month to Christmas, Brent is now trading at US$65/b and WTI maintaining its steady discount at US$55/b. How did the market get it so wrong?
The main lynchpin is supply. Just as the sanctions went into effect on November 3, the USA issued surprise waivers to 8 key importers of Iranian crude, including China, India and South Korea. This had been bandied about in the lead up to November 3, with South Korea even eschewing all Iranian crude in September and India cutting down dramatically to qualify. The scope of the waivers was larger than expected, despite American rhetoric that the sanctions would be ‘tougher’ than Obama-era measures. Ostensibly, the waivers were issued due to the market being ‘fragile’, but also it also acknowledges the reality that it will be impossible to remove all Iranian crude trade without causing a supply crunch. So instead of reducing Iran’s exports ‘to zero’, the White House seems to have settled on reducing it to 1 mmb/d or so.
At the same time, President Trump’s Twitter demands that OPEC increase its supply was heeded. Saudi Arabia claimed that OPEC was in a ‘pump as much as we can’ mode, with the Kingdom’s crude exports rising to record highs, along with that other large producer Russia. With increased supply from OPEC more than offsetting losses in Iran, the market swung from fears of a supply crunch to oversupply. On November 13, Brent dropped by almost US$5/b as market dynamics changed course; it wasn’t just supply growing, but also demand retreating, as warned by the EIA and IEA. OPEC also commented that it was seeing ‘declining demand for its crude’, revising its demand forecast downwards for the fourth month in a row – news that spooked traders in the market, especially given that China’s overall economic growth is also slowing down.
So crude oil benchmarks are now trading at nearly 20% lower than they were a month ago. That’s officially a bear market. What happens next?
Probably to the chagrin of Donald Trump – although the issue is less vital now that American midterm elections are over – Saudi Arabia is looking to make a U-turn, proposing an output cut of some 1mmb/d ahead of the OPEC meeting in Vienna in two weeks. Other allies within the OPEC+ circle are less keen on changing course, with Russia stating that producers should look to avoid knee jerk reactions to momentary price signals. That said, Vladimir Putin has also stated that oil at ‘US$70/b suits us completely’, a sentiment echoed across OPEC. So instead of taming prices, OPEC now has the onerous task to propping them up. But it’ll be easier said than done; the current glut in the crude market is for light, sweet grades, not the heavier, sourer crudes produced by OPEC.
Will it happen? Yes, it will. Producers have gotten used to US$70/b oil and with signs showing that Brent could fall as low as US$60/b in the next few weeks, they will be eager to shore things up. The slate of new upstream projects approved in the second half of 2018 require relatively strong crude prices to be economic. US$80/b oil might be too high, US$60/b oil might be too low, but US$70/b oil seems just right. And now it is up to OPEC+ to see if they can convince the market to return to that point.
Recent Brent Prices:
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Recent headlines on the oil industry have focused squarely on the upstream side: the amount of crude oil that is being produced and the resulting effect on oil prices, against a backdrop of the Covid-19 pandemic. But that is just one part of the supply chain. To be sold as final products, crude oil needs to be refined into its constituent fuels, each of which is facing its own crisis because of the overall demand destruction caused by the virus. And once the dust settles, the global refining industry will look very different.
Because even before the pandemic broke out, there was a surplus of refining capacity worldwide. According to the BP Statistical Review of World Energy 2019, global oil demand was some 99.85 mmb/d. However, this consumption figure includes substitute fuels – ethanol blended into US gasoline and biodiesel in Europe and parts of Asia – as well as chemical additives added on to fuels. While by no means an exact science, extrapolating oil demand to exclude this results in a global oil demand figure of some 95.44 mmb/d. In comparison, global refining capacity was just over 100 mmb/d. This overcapacity is intentional; since most refineries do not run at 100% utilisation all the time and many will shut down for scheduled maintenance periodically, global refining utilisation rates stand at about 85%.
Based on this, even accounting for differences in definitions and calculations, global oil demand and global oil refining supply is relatively evenly matched. However, demand is a fluid beast, while refineries are static. With the Covid-19 pandemic entering into its sixth month, the impact on fuels demand has been dramatic. Estimates suggest that global oil demand fell by as much as 20 mmb/d at its peak. In the early days of the crisis, refiners responded by slashing the production of jet fuel towards gasoline and diesel, as international air travel was one of the first victims of the virus. As national and sub-national lockdowns were introduced, demand destruction extended to transport fuels (gasoline, diesel, fuel oil), petrochemicals (naphtha, LPG) and power generation (gasoil, fuel oil). Just as shutting down an oil rig can take weeks to complete, shutting down an entire oil refinery can take a similar timeframe – while still producing fuels that there is no demand for.
Refineries responded by slashing utilisation rates, and prioritising certain fuel types. In China, state oil refiners moved from running their sites at 90% to 40-50% at the peak of the Chinese outbreak; similar moves were made by key refiners in South Korea and Japan. With the lockdowns easing across most of Asia, refining runs have now increased, stimulating demand for crude oil. In Europe, where the virus hit hard and fast, refinery utilisation rates dropped as low as 10% in some cases, with some countries (Portugal, Italy) halting refining activities altogether. In the USA, now the hardest-hit country in the world, several refineries have been shuttered, with no timeline on if and when production will resume. But with lockdowns easing, and the summer driving season up ahead, refinery production is gradually increasing.
But even if the end of the Covid-19 crisis is near, it still doesn’t change the fundamental issue facing the refining industry – there is still too much capacity. The supply/demand balance shows that most regions are quite even in terms of consumption and refining capacity, with the exception of overcapacity in Europe and the former Soviet Union bloc. The regional balances do hide some interesting stories; Chinese refining capacity exceeds its consumption by over 2 mmb/d, and with the addition of 3 new mega-refineries in 2019, that gap increases even further. The only reason why the balance in Asia looks relatively even is because of oil demand ‘sinks’ such as Indonesia, Vietnam and Pakistan. Even in the US, the wealth of refining capacity on the Gulf Coast makes smaller refineries on the East and West coasts increasingly redundant.
Given this, the aftermath of the Covid-19 crisis will be the inevitable hastening of the current trend in the refining industry, the closure of small, simpler refineries in favour of large, complex and more modern refineries. On the chopping block will be many of the sub-50 kb/d refineries in Europe; because why run a loss-making refinery when the product can be imported for cheaper, even accounting for shipping costs from the Middle East or Asia? Smaller US refineries are at risk as well, along with legacy sites in the Middle East and Russia. Based on current trends, Europe alone could lose some 2 mmb/d of refining capacity by 2025. Rising oil prices and improvements in refining margins could ensure the continued survival of some vulnerable refineries, but that will only be a temporary measure. The trend is clear; out with the small, in with the big. Covid-19 will only amplify that. It may be a painful process, but in the grand scheme of things, it is also a necessary one.
Infographic: Global oil consumption and refining capacity (BP Statistical Review of World Energy 2019)
|Region||Consumption (mmb/d)*||Refining Capacity (mmb/d)|
*Extrapolated to exclude additives and substitute fuels (ethanol, biodiesel)
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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