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Unprecedented is a word that has captured headlines since January 2020, when the Covid-19 pandemic first began to accelerate in China. Unprecedented contagion, unprecedented lockdowns, unprecedented demand destruction, all leading up to what could be the worst economic recession since the Great Depression almost a century ago. And now, unprecedented oil prices, as the WTI crude price marker slipped into negative territory for the first time ever.
Not just any negative territory, but double digits negative. The front month WTI contract for deliveries in May fell as low as -US$37.63.b on Monday. The discount between WTI and Brent also crashed to its lowest point ever, at a peak of -US$62/b, as Brent continues to trade in the mid-US$20/b level. That’s unprecedented. It isn’t just WTI; other US grades are also deep in the negative, as well as Western Canada Select. This essentially means American and Canadian producers are paying to offload their crude oil to (a thin pool) of potential buyers.
There are many reasons for this. Demand for refined fuels has virtually dried up as the US imposed strict lockdown conditions to contain the virus. Jet travel has evaporated, and though gasoline prices have reportedly fallen by 75% in some parts of the US, there is nowhere to drive to. At least three North American refineries have been idled in the face of oil demand destruction, and there are certainly more to come. Try as much as President Donald Trump wants to re-open the US economy, the threat of the virus re-accelerating is worse. This huge dip in demand and refining meant that all the crude and shale oil being produced had nowhere to go but into storage. But storage is rapidly getting maxed out; spare capacity in the main hub of Cushing is fast depleting, and there are even plans to store oil in train cars and in halted pipelines. Storage in the US Strategic Petroleum Reserve is available, but even that is limited.
What makes this even more unprecedented is that much of this oil is onshore, very far inland. This had the same effect, though different contributing factors in 2019, when WTI prices were depressed because demand was high but pipeline capacity was insufficient to carry crude to refining centres along the US Gulf Coast, creating a shale glut. In a way, that paved the way to the current catastrophe; many shale producers picked up a lot of debt during this time, and were forced to pump oil even more aggressively just to stay alive. In the world of a growing oversupply, inland oil is overflowing as storage fills to the brim. Offshore production doesn’t face the same issue. As long as crude can be delivered on the coast, it can be placed on a tanker and stored offshore indefinitely, especially with so many ships idled due to the slowdown in economic activity. This is already happening in Singapore, in Fujairah, in the North Sea, and is the reason that the global crude marker, Brent, has not collapsed.
But the main reason for the unprecedented demolition of US crude prices hinges on a technicality. The Brent NYMEX contract is settled in cash. WTI contracts, however, are settled physically; those holding the contract must therefore take physical delivery at expiry. That expiry date for May contracts is April 21. The dive into deep red territory came because of extreme selling pressure to avoid have to physically receive the oil, especially with nowhere onshore to store it. News that large cargoes of Saudi crude were heading to the US Gulf made matters worse. However, further WTI futures contracts for June and beyond, are still trading at a far more normal range of US$20-30/b; there is still enough time for demand to recover (or for more storage to be found) for these contracts. But for the May contract? It is a bloodbath.
The situation certainly isn’t as dire as it seems, though the headlines might seem apocalyptic. This knee-jerk reaction will almost certainly sort itself out over the medium term. Already, the expiring May WTI contract recovered to -US$6/b in after-hours trading. WTI should return to a more normal range with the switchover to the June benchmark contract on Wednesday. Economic pressure will keep prices low, but not that low. At least not yet. But it will be a whole new galaxy of pain for the US oil industry, especially those that are completely reliant on shale and those that service them. The Saudi-Russia oil price war may have begun as a battle for market share, but might have inadvertently achieved a secondary objective, wiping out US shale production that was undermining supply control efforts. In just three months, the entire oil world has been turned upside down. In response, the industry is recalibrating. There will be some winners, and some losers. In these unprecedented times, expect unprecedented things.
WTI’s Great Fall:
-Traded prices on NYMEX, 20 April 2020
- 10am: US$11.28/b
- 2pm: US$4.88/b
- 2.30pm: -US$0.02/b
- 3pm: -US$.6.89/b
- 4pm: -US$37.63/b
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Source: U.S. Energy Information Administration, Short-Term Energy Outlook (STEO)
In its January 2020 Short-Term Energy Outlook (STEO), the U.S. Energy Information Administration (EIA) forecasts that annual U.S. crude oil production will average 11.1 million b/d in 2021, down 0.2 million b/d from 2020 as result of a decline in drilling activity related to low oil prices. A production decline in 2021 would mark the second consecutive year of production declines. Responses to the COVID-19 pandemic led to supply and demand disruptions. EIA expects crude oil production to increase in 2022 by 0.4 million b/d because of increased drilling as prices remain at or near $50 per barrel (b).
The United States set annual natural gas production records in 2018 and 2019, largely because of increased drilling in shale and tight oil formations. The increase in production led to higher volumes of natural gas in storage and a decrease in natural gas prices. In 2020, marketed natural gas production fell by 2% from 2019 levels amid responses to COVID-19. EIA estimates that annual U.S. marketed natural gas production will decline another 2% to average 95.9 billion cubic feet per day (Bcf/d) in 2021. The fall in production will reverse in 2022, when EIA estimates that natural gas production will rise by 2% to 97.6 Bcf/d.
Source: U.S. Energy Information Administration, Short-Term Energy Outlook (STEO)
EIA’s forecast for crude oil production is separated into three regions: the Lower 48 states excluding the Federal Gulf of Mexico (GOM) (81% of 2019 crude oil production), the GOM (15%), and Alaska (4%). EIA expects crude oil production in the U.S. Lower 48 states to decline through the first quarter of 2021 and then increase through the rest of the forecast period. As more new wells come online later in 2021, new well production will exceed the decline in legacy wells, driving the increase in overall crude oil production after the first quarter of 2021.
Associated natural gas production from oil-directed wells in the Permian Basin will fall because of lower West Texas Intermediate crude oil prices and reduced drilling activity in the first quarter of 2021. Natural gas production from dry regions such as Appalachia depends on the Henry Hub price. EIA forecasts the Henry Hub price will increase from $2.00 per million British thermal units (MMBtu) in 2020 to $3.01/MMBtu in 2021 and to $3.27/MMBtu in 2022, which will likely prompt an increase in Appalachia's natural gas production. However, natural gas production in Appalachia may be limited by pipeline constraints in 2021 if the Mountain Valley Pipeline (MVP) is delayed. The MVP is scheduled to enter service in late 2021, delivering natural gas from producing regions in northwestern West Virginia to southern Virginia. Natural gas takeaway capacity in the region is quickly filling up since the Atlantic Coast Pipeline was canceled in mid-2020.
Just when it seems that the drama of early December, when the nations of the OPEC+ club squabbled over how to implement and ease their collective supply quotas in 2021, would be repeated, a concession came from the most unlikely quarter of all. Saudi Arabia. OPEC’s swing producer and, especially in recent times, vocal judge, announced that it would voluntarily slash 1 million barrels per day of supply. The move took the oil markets by surprise, sending crude prices soaring but was also very unusual in that it was not even necessary at all.
After a day’s extension to the negotiations, the OPEC+ club had actually already agreed on the path forward for their supply deal through the remainder of Q1 2021. The nations of OPEC+ agreed to ease their overall supply quotas by 75,000 b/d in February and 120,000 b/d in March, bringing the total easing over three months to 695,000 b/d after the UAE spearheaded a revised increase of 500,000 b/d for January. The increases are actually very narrow ones; there were no adjustments for quotas for all OPEC+ members with the exception of Russia and Kazakshtan, who will be able to pump 195,000 additional barrels per day between them. That the increases for February and March were not higher or wider is a reflection of reality: despite Covid-19 vaccinations being rolled out globally, a new and more infectious variant of the coronavirus has started spreading across the world. In fact, there may even be at least of these mutations currently spreading, throwing into question the efficacy of vaccines and triggering new lockdowns. The original schedule of the April 2020 supply deal would have seen OPEC+ adding 2 million b/d of production from January 2021 onwards; the new tranches are far more measured and cognisant of the challenging market.
Then Saudi Arabia decides to shock the market by declaring that the Kingdom would slash an additional million barrels of crude supply above its current quota over February and March post-OPEC+ announcement. Which means that while countries such as Russia, the UAE and Nigeria are working to incrementally increase output, Saudi Arabia is actually subsidising those planned increases by making a massive additional voluntary cut. For a member that threw its weight around last year by unleashing taps to trigger a crude price war with Russia and has been emphasising the need for strict compliant by all members before allowing any collective increases to take place, this is uncharacteristic. Saudi Arabia may be OPEC’s swing producer, but it is certainly not that benevolent. Not least because it is expected to record a massive US$79 billion budget deficit for 2020 as low crude prices eat into the Kingdom’s finances.
So, why is Saudi Arabia doing this?
The last time the Saudis did this was in July 2020, when the severity of the Covid-19 pandemic was at devastating levels and crude prices needed some additional propping up. It succeeded. In January 2021, however, global crude prices are already at the US$50/b level and the market had already cheered the resolution of OPEC+’s positions for the next two months. There was no real urgent need to make voluntary cuts, especially since no other OPEC member would suit especially not the UAE with whom there has been a falling out.
The likeliest reason is leadership. Having failed to convince the rest of the OPEC+ gang to avoid any easing of quotas, Saudi Arabia could be wanting to prove its position by providing a measure of supply security at a time of major price sensitivity due to the Covid-19 resurgence. It will also provide some political ammunition for future negotiations when the group meets in March to decide plans for Q2 2021, turning this magnanimous move into an implicit threat. It could also be the case that Saudi Arabia is planning to pair its voluntary cut with field maintenance works, which would be a nice parallel to the usual refinery maintenance season in Asia where crude demand typically falls by 10-20% as units shut for routine inspections.
It could also be a projection of soft power. After isolating Qatar physically and economically since 2017 over accusations of terrorism support and proximity to Iran, four Middle Eastern states – Saudi Arabia, Bahrain, the UAE and Egypt – have agreed to restore and normalise ties with the peninsula. While acknowledging that a ‘trust deficit’ still remained, the accord avoids the awkward workarounds put in place to deal with the boycott and provides for road for cooperation ahead of a change on guard in the White House. Perhaps Qatar is even thinking of re-joining OPEC? As Saudi Arabia flexes its geopolitical muscle, it does need to pick its battles and re-assert its position. Showcasing political leadership as the world’s crude swing producer is as good a way of demonstrating that as any, even if it is planning to claim dues in the future.
It worked. It has successfully changed the market narrative from inter-OPEC+ squabbling to a more stabilised crude market. Saudi Arabia’s patience in prolonging this benevolent role is unknown, but for now, it has achieved what it wanted to achieve: return visibility to the Kingdom as the global oil leader, and having crude oil prices rise by nearly 10%.
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