How low can oil still go?

How low can oil still go?

/ Financial News / Monday, 30 March 2020 12:21

One doesn’t need a degree in economics or finance to understand that this situation is unsustainable and it is worsening by the day now that prices have tanked. What’s next? 

The wave of oil industry spending cuts continues, with the majors now announcing significant reductions to spending as oil remains stuck in the range of $20. Royal Dutch Shell said that it would cut spending by 20 percent, or about $5 billion, and also suspend its share buyback plan. French oil giant Total SA and Norway’s Equinor announced similar moves.

ExxonMobil and Chevron have suggested they too would be axing their budgets, with Exxon under particular pressure. Goldman Sachs estimates that Chevron needs $50 per barrel in order to cover spending and its dividend. ExxonMobil, on the other hand, needs around $70. 

The majors are relatively more spared from the downturn than small and medium-sized shale drillers because they have downstream refining and petrochemical assets that have typically performed somewhat better than upstream units when prices fall. Refineries, for instance, spend less on oil during the downturn, and low prices also translate into a boost in sales of refined products.

However, the majors shouldn’t let their guards down this time around. We are in the midst of a historic meltdown – a supply crisis and a demand event with no precedent. Estimates vary, but oil consumption could be off by 10 million barrels per day (mb/d), or more. It doesn’t matter how cheap crude is. If there’s no use for it since people are not driving, flying or consuming anything aside from the bare essentials, there is no demand boost resulting from low prices. 

In a statement, Exxon announced that it was cutting production at its Baton Rouge refinery, the company’s second largest in the U.S., because poor demand has filled up storage tanks. Exxon also cut 1,800 contractors from the site.

The first round of spending cuts from the oil industry is now visible, but a second round is beginning, according to a report by Goldman Sachs. 

“We see US oil production falling almost 1.4 mn bpd over five quarters post Q2 2020 based on reduced drilling (i.e., before considering shut-ins of existing wells that are likely to be needed) with covered company capex down 35% year-on-year in 2020,” Goldman Sachs wrote in a note. 

However, budget revisions are not over. The slide in spending, drilling and ultimately in output could deepen as capex cuts grow more pronounced. “There is no sugar coating it, U.S. oilfield activity will collapse with oil prices well below $30 WTI,” Raymond James said. The initial round of cuts put spending at about 45 percent below 2019 levels, the bank said. “However, the declines will be far more dramatic than these initial cuts and we stress that these announcements skew towards larger cap, better hedged and capitalized operators.” 

“Total U.S. capex is likely to fall in excess of 65% with a WTI price persisting in the $20s,” the investment bank concluded. 

Rystad Energy put out a similar estimate. According to the Oslo-based firm, E&Ps are likely to cut project sanctioning by up to $131 billion, or about 68% year-on-year. “Upstream players will have to take a close look at their cost levels and investment plans to counter the financial impact of lower prices and demand. Companies have already started reducing their annual capital spending for 2020,” says Audun Martinsen, Rystad Energy’s head of energy service research.

There are many possibilities on how low WTI and Brent can go. But more than a few analysts have pointed to the potential for storage to max out as a reason why prices have more room to fall. “No one can exactly be sure that production will be shut-in fast enough to not overwhelm our ability to store oil,” JBC Energy said in a note. The firm pointed to refineries cutting processing because they are running out of storage, such as Exxon’s Baton Rouge. “In such an environment, it is as possible for Brent prices to briefly go to $10 per barrel as it was back in 1986 or 1998,” JBC concluded. 

Oil majors are scrambling to find places to store crude oil. Recently, Shell was looking to charter three VLCCs to store crude oil in anticipation of the deluge of oil that Saudi Arabia was planning to export. But storage space is finite. 

FitchRatings updated its price forecasts for oil “in expectation of very large market oversupply in 2020.”

According to Bjornar Tonhaguen of Rystad Energy, “the market will soon come to realize that it may be facing one of the largest supply surpluses in modern oil market history in April.”

And if the tight crude oil storage isn’t enough of an issue, oil majors are also looking to store jet fuel at sea—a far trickier endeavor than storing crude oil due to its more delicate nature.

Saudi-Russia price war

Oil prices were mixed in volatile Asian trade, but remained at multi-year lows due to the double shock of the coronavirus pandemic and the Saudi-Russia price war.

International benchmark Brent crude was off 2.3 percent at $26 a barrel. US benchmark West Texas Intermediate however was up 1.3 percent at nearly $23 a barrel as traders bought at bargain prices – after having fallen over three percent in earlier deals.

Both contracts remain at multi-year lows as lockdowns and travel restrictions to fight the virus hit demand, and top producers Saudi Arabia and Russia engage in a price war.

Coronavirus deaths soared across Europe and the United States despite heightened restrictions. Prices also fell after a trillion-dollar Senate proposal to rescue the US economy was defeated because of zero support from Democrats, and with five Republicans absent from the chamber because of virus-related quarantines. The bill had proposed funding for American families, thousands of shuttered or suffering businesses and the nation's critically under-equipped hospitals.

Oil markets began plunging earlier this month after top exporter Saudi Arabia launched unilateral price cuts following a failure to secure an agreement with Russia to further reduce output and support prices.

There were hopes for some action to support the market after an envoy from Texas, a top oil-producing US state, was given a rare invite to an OPEC meeting in June. But hopes for an agreement fizzled after he faced criticism for suggesting output curbs.

Even if cuts are agreed at some point, they “alone will not be enough to see prices fully recover the lost ground over the last month”, said Peter Kiernan, energy analyst from the Economist Intelligence Unit. “This would need a noticeable recovery in demand, which is unlikely in the short to medium term.”

US to Saudis: ‘reassure’ oil and financial markets

As the world grapples with a coronavirus pandemic that has paralyzed major economies, the United States has urged Saudi Arabia to “reassure” oil and financial markets. The appeal was made by Secretary of State Mike Pompeo in a telephone conversation with Crown Prince Mohammed bin Salman, the State Department said.

Saudi Arabia will trim this year's budget by around five percent, the finance minister said, in its first austerity measure as the economy reels from the fast-spreading coronavirus and crashing oil prices.

The country is bracing for an economic slump after it shut down cinemas, malls and restaurants, suspended the year-round umrah pilgrimage and locked down eastern Qatif region – home to around 500,000 people – in a bid to contain the deadly coronavirus.

The Energy Intelligence Group says the kingdom has asked government bodies to prepare budget scenarios in which crude prices could drop as low as $12-$20 per barrel.

The deep-pocketed kingdom, with fiscal reserves of around $500 billion, has reiterated it is an ultra-low-cost producer of crude and can withstand low prices for years. But Riyadh has posted a budget deficit every year since the last oil price rout in 2014. It has borrowed over $100 billion and drawn from its reserves to plug the deficit.

Late last year, the kingdom projected a budget deficit of $50 billion in 2020 as spending was projected at $272 billion. The budget shortfall is expected to jump substantially as crude prices decline. Saudi Arabia needs a crude price of about $80 a barrel to balance its budget.

President Donald Trump, who is seeking re-election in November, has welcomed lower gasoline prices for US consumers but the United States is also worried about its shale oil producers.

“The Secretary stressed that as a leader of the G20 and an important energy leader, Saudi Arabia has a real opportunity to rise to the occasion and reassure global energy and financial markets when the world faces serious economic uncertainty,” the department said in a statement.

“We agreed all countries need to work together to contain the pandemic and stabilize energy markets,” Pompeo himself tweeted.

History will “judge”

The executive director of the International Energy Agency (IEA), Fatih Birol, criticizes the role of Saudi Arabia and Russia in the current fall in oil prices, estimating that the current “history will judge them”, in an interview with Les Echos.

“The citizens of the world will remember that the great powers that had the power to stabilize the economies of many countries in a period of unprecedented pandemic decided not to exercise it. History will judge them,” he says on the daily's website, pointing out the risk of destabilization in some producer countries.

Saudi Arabia, which chose to flood the market despite the collapse in demand with the pandemic of the new coronavirus, “is hurting itself by bringing down prices” but is acting for “political and diplomatic considerations,” he observes.

Russia, which has refused new agreements with the Organization of Petroleum Exporting Countries (OPEC) to limit their production, is playing a “game of Russian roulette” to wipe out shale oil production in the United States, but “it won't work,” according to Fatih Birol.

Oil prices have collapsed with the pandemic of the new coronavirus, which is causing demand to fall, but also because of the inability of producer countries to reach an agreement. They are currently trading below $30 a barrel.

The IEA had from the beginning of the crisis expressed its fear of impacts. This is a "major" economic and social challenge for oil-producing countries, especially the most vulnerable, such as Iraq, Angola or Nigeria.


Saudi Aramco says it will cut investment to $25-$30 billion this year, a modest drop on the $32.8 billion it spent last year.

“Based on this unprecedented environment, we are evaluating all appropriate steps to significantly reduce capital and operating expenses in the near term," said Exxon Mobil Corporation's chief executive Darren Woods.

British oil major BP is targeting a 20 percent drop in spending this year, its chief financial officer Brian Gilvary said in an interview on Bloomberg television.

Poor returns

Environmental activists can barely hide their joy at the difficulties the oil industry faces.

“We consider it is pretty much good news considering that these (exploration and development) projects shouldn't see the light of day given the urgency of climate change,” said Cecile Marchand of the French chapter of Friends of the Earth.

She acknowledged abandoning these projects may not be permanent unless major political and economic policy changes are made.

Marchand also warned of the risk of “a concentration of the market in the hands of the majors who are more resilient that the small firms.”

Elmes at Warwick Business School said some positive outcomes were also possible.

The European oil and gas majors have already indicated they intend to reduce their reliance on these fuels and become more active in renewables such as wind and solar.

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