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A wild rodeo ride for the oil market

Observing the oil market feels like watching a rodeo these days. After falling to multi-year lows mid-last week, oil prices surged around 50% as the leading oil producers openly mulled supply cuts. What are the consequences of the double shock of pandemics and oil politics?

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The oil market suffers from the double shock of pandemics and oil politics. The exceptionally fast and deep oil price sell-off marks the beginning of a period of relentlessly swelling surpluses and economic hardship for the business and petro-nations alike, similar to the situation between 2014 and 2016. Governments around the world respond to the coronavirus outbreak with widespread lockdown measures. One of the longest-lasting business cycles comes to an abrupt end, as the world economy dives into contraction with everyday life put into hibernation. Oil demand collapses, as the health measures curb mobility needs. Real-time indicators provide a glimpse of the magnitude:

The second shock, purely affecting the oil market, is the U-turn in oil policy. The so-called OPEC+ deal, which has partly shaped the oil market over the past years, has now fallen apart. The leading petro-nations Saudi Arabia and Russia locked horns on raising supplies. The deal always had its limitations, because the oil prices required for balanced petro-nation budgets are significantly higher than the oil prices needed for profitable US shale operations. Thus, instead of providing a more comfortable life for the signatories, it resulted in market-share gains for the shale producers. There are two sides to this U-turn in oil politics. The decision to terminate the framework of supply coordination had some rationality to it ahead of the pandemic, given the deal’s inherent limitations. Saudi Arabia’s motivation to raise output, on the other hand, remains elusive and seems more emotional than rational, especially under the current market circumstances.   

What are the broader consequences?
The consequences for the oil market are drastic and lead to a supply glut that heavily pressures prices. The collapse of consumption requires a swift adjustment of production, in order to prevent the market from running out of storage capacity in the months to come. Without intervention from oil policy, it is now fully up to the market to rebalance supply and demand. The stage is set for a period of low prices, turmoil and hardship, as seen during 2014–2016. The oil business rests on comparably long investment decision times and thus supply reacts to changes in demand only with a time lag. In consequence, the price moves needed to force production adjustments to changed market conditions can be very wild, just as we witness these days. Today’s price levels at around USD 25 per barrel force producers to reduce output and stimulate demand, thus the fundamental processes to rebalance the oil market are in motion. Unlike 2014, the trigger is cyclically collapsing demand, and not structurally growing supply. Moreover, the oil business has shown financial frugality as of late because of investors’ focus on costs, profitability and climate change, and does not come out of a period of commodity super-cycle exuberance framed by a growth-focused mindset. Compared to the period between 2014 and 2016, today’s shock is heftier, the adjustment faster and the recovery likely also swifter. 

The petro-nations, meanwhile, are up for longer-term pain. Sovereign wealth funds in part offset the drying-up of petro-dollar revenues. However, the global recession raises fiscal expenditures just at a time when revenues collapse. The sovereign wealth funds only provide a breather before economic reform is due in order to curb dependencies on oil revenues. Russia seems somewhat better placed than Saudi Arabia for different reasons. The free-floating currency cushions the impact of lower oil prices on earnings of the domestic oil business. The past year’ sanctions regime fostered technological and financial independence. In fact, the process of adjusting a petro-nation’s economy and its underlying social contracts likely entails more frictions and hardship than the adjustments of the shale industry to current market conditions. The shale business responsiveness also entails the ability to restart swiftly and ramp up output when conditions improve.

Will we see a revival of oil politics?
The chances should not be underestimated. The United States, Russia and Saudi Arabia have a common interest not to aggravate the oil shock so as to help ease the pain somewhat. Given Saudi Arabia’s dependence on US support, and given the US sanctions on Russia, there are some trump cards on the table of global oil politics. Although Saudi Arabia pledged to raise supplies over the coming weeks, it is doubtful that the country will find many buyers for its oil. Various refiners have approached the state oil company in order to delay and not to advance deliveries for weeks to come, according to news sources. Moreover, Saudi Arabia might feel the pressure, not least from the G20 presidency, to turn more conciliatory. In brief, both the individual motivations and the policy options seem numerous. Besides a multilateral ‘ceasefire deal’, the US government could unilaterally choose among different measures, including Congress limiting military support, putting tariffs on Saudi oil imports, or standing behind the Texas railroad commission exercising its competence to mandate production cuts within the state.

Amidst this uncertainty, some elements are relatively clear

The oil shock aggravates the security situation in the Middle East, fuels social turmoil, and could potentially revive the dormant ‘Arab Spring’. Venezuela’s regime extended its life expectancy last year thanks to economic reforms, but the oil shock and lack of petro-dollars might accelerate a vicious circle of production declines and drying-up of government revenues.  
 
These uncertainties with regard to the size of the demand shock, the duration of the economic downturn, and possibilities of a different kind of oil politics, suggest that oil prices will continue to swing wildly up and down in the very near term. Importantly, an oil policy revival becomes more likely the lower oil goes and thus forms a kind of floor for prices. Looking further ahead, we see more upside than downside from today’s levels and project oil prices to move beyond USD 40 early next year. The mood looks as bearish as it gets, which is usually a solid indicator for troughs. The demand collapse is deep but only temporary, with a recovery beginning in the third quarter this year. Meanwhile, production is set to decline relatively swiftly, primarily in North America, slowing the initially fast storage builds towards the end of the year.

The oil glut will last well into 2021, putting pressure on prices
In the bear case, i.e. pessimistic scenario, oil prices would stay in the low 20s for longer, as the deep but short recession turns into a longer-lasting depression requiring even larger curtailments of production. In addition, the oil markets’ long-term cost anchor is set to move lower. The shale industry’s competitiveness should improve further as the remaining operators overcome the oil shock in stronger shape and with lower costs. For the upcoming decade of plateauing oil use, with electric mobility spreading, we see the oil market structurally balanced at USD 50 per barrel. 
 

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