March 9, 2020

Saudi Arabia attempting a scorched earth strategy to get a production cut.

Executive Summary: Global markets are attempting to price in the double-whammy of the Saudi price cut and production increases, all while trying to gauge the COVID-19 impact to the global economy. We anticipate continued price swings for crude oil, which may get pushed down into the low $20s.

What Happened

Global crude oil prices plunged more than 30% in trading on Asian markets on March 9 (Sunday night for US). In the US, crude oil prices† declined nearly $12 on the open to $30 per barrel on Sunday night. That is more than a 50% drop year to date, having ended 2019 at $61.06 per barrel.

The Organization of Petroleum Exporting Countries (OPEC) held meetings in Vienna this past Thursday. On Friday, OPEC held meetings with the wider OPEC+ group, which is OPEC member countries plus the 10 non-OPEC nations—most notably, Russia, Mexico and Kazakhstan (collectively known as OPEC+).

These were regularly scheduled meetings, but in light of the drop of roughly $15 per barrel prior to the OPEC meetings due to the coronavirus (COVID-19) outbreak, global markets widely anticipated that OPEC+ would agree to a production cut. Instead, the opposite occurred.

After the breakdown of extended talks, Saudi Arabia—through its state-controlled energy company Saudi Aramco—immediately dropped the price offered for March deliveries by $6 to $8 depending on the country. Furthermore, Saudi sources let it be known that Saudi Aramco plans to increase output in April to above 10 million barrels a day (mbd) from about 9.74 mbd in February and could allow it to climb as high as 12 mbd. Saudi Arabia’s moves appear to be intended to gain market share and punish their adversaries within OPEC+.

Context: Saudi Arabia’s Leadership

Saudi Arabia has long been the leader of OPEC, accounting for approximately a third of OPEC production, and generally dictating production quotas to other members. Alternatively, Saudi Arabia has typically felt the pain of taking the brunt of production cuts “for the good of the group” when necessary, which translates into lost market share and revenue for the kingdom.

As the chart above shows, Saudi production has averaged roughly 10 mbd for the past ten years (2010 through 2019). The kingdom reportedly has capacity of 11.5 mbd, but has only once ever pumped more than 11 mbd, which was 11.07 mbd in November 2018 and only for the one month. Moreover, following the September 2019 attacks on Saudi oil infrastructure, the exact Saudi capacity remains unknown, particularly its port loading capabilities. Accordingly, we are skeptical that the Saudi production could stay much above 11 mbd for an extended period without a rather large investment to upgrade export capacity.

What’s Next

The Saudi moves appear to be intended to force OPEC+ to agree to a production cut. Russia is among the key holdouts for production cuts and grudgingly agreed to relatively modest cuts over the past few years. The flood of excess production will push revenue downward for all producers, although most OPEC+ producers are controlled by their respective governments. That said, Saudi Aramco is now a publicly-traded company, having floated roughly 1.5% of the company’s shares to outside investors as part of a $29 billion initial public offering back in December. This could complicate the calculation for the kingdom if global investors sour on Saudi Aramco.

Nonetheless, previously similar brute force attempts by the Saudis to get OPEC production cuts have backfired. The most recent example was in late 2014, when Kuwait, the United Arab Emirates and Venezuela balked at reduced production quotas. The kingdom boosted production in early 2015, which pushed prices down roughly 45% over the next year to $26 per barrel. Finally, OPEC agreed to new production cuts, but the kingdom took the bulk of the reduction.

Sooner or later the pain of lost profits typically prevails. However, it might take more pain for OPEC+ to arrive at that point. Conversely, ignoring the egos and pride involved, this issue could be resolved relatively quickly.

US Economic Impact

The US economic impact of the sharp decline in crude oil prices is not as large as it has been in the past, whereby a drop in price was a clear benefit to US consumers and the economy, particularly as the US has increasingly produced and exported crude oil.

The amount of economic activity generated from one unit of crude oil has steadily increased over the past quarter century, improving 61% for the US since 1990 thanks to new technologies, which have driven fuel efficiency and alternative energy sources, including natural gas for transportation. While lower gasoline prices will certainly help low-income Americans keep a little more of their hard-earned money, the savings for most Americans and US-based companies is not as large. Ultimately, this means that the US economy gets less lift by lower crude oil prices than it had during prior business cycles.

Additionally, with the size of US crude oil production nearing 13 mbd, the decline in prices negatively impacts US energy investment, including the build-out of increased exploration and production as well as pipelines to carry crude oil and natural gas to end markets. In the past 20 years, US employment in oil & gas extraction and support activities has grown 80% to just over 400,000 workers. Thus, the sharp decline in crude oil prices puts some of these jobs and investment at risk.

Bottom Line

Global markets are attempting to price in the double-whammy of the Saudi price cut and production increases, all while trying to gauge the COVID-19 impact to the global economy. In our opinion, this is too many moving parts for global markets to digest. We anticipate continued price swings for crude oil. Our initial take is that crude oil prices will continue to slide lower before this issue is resolved, perhaps down to the low $20s.

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CN2020-0563 EXP12-2020