As air travel slams to a virtual halt and traffic on the world’s freeways is reduced to a minimum the oil market has suffered a substantial destruction of demand, with prices plummeting.
Yet, on an historic level, the US has brokered negotiations between OPEC and Russia and, along with the International Energy Agency, has convinced Saudi Arabia to call on the G20 to engineer a coordinated response to the dramatic slump in oil demand.
Over Easter, fraught last-minute negotiations with Mexico, the most stubborn participant, have also helped cement supply reductions. The G20 appears to have signalled a willingness to reduce output, amid commitments by the US, Brazil and Canada.
Goldman Sachs suspects production cuts from these three are unlikely to be voluntary and will be driven by market forces. They are likely to occur over time, given the significant geological and regulatory hurdles involved in reducing production. What the agreement couldn’t achieve in size it has attempted to do in terms of duration and the broker notes numbers are rubbery. OPEC and Russia will meet again in June.
Shaw and Partners, too, does not hand the oil players an Oscar, believing, irrespective of their efforts, a rapid recovery in demand is required to address the potential oversupply, and this is highly uncertain.
Assessing previous oil cycles over four decades, the broker points out inventory overhang can take 1-2 years to clear and that only happens when supply is lower than demand. When demand does eventually recover, market concerns shift to the large shut-in capacity that needs to be taken on board.
Like other production agreements, Citi asserts there is ambiguity and fudging amid confusion over what baseline applies to which country. Still, the targets are reasonably clear.
OPEC et al (23 countries) will reduce exports by around -9.7mb/d in May and June, followed by a relaxation to -7.7mb/d for the second half of 2020 and to -5.8mb/d for January 2021-April 2022. The latter number will be reassessed by December 2020.
Canaccord Genuity is more optimistic about the deal, noting Saudi Arabia, as the largest producer, has taken the biggest cut to its production and shown a willingness to ramp up production if partners don’t cooperate.
Producers, besides OPEC and Russia, are committing to reductions, although the broker acknowledges there are concerns these commitments are not genuine and will be a function of prices rather than policy.
Still, Citi anticipates they will occur, and will be less subject to any quick reversal compared with the ease at which OPEC and Russia can change tactics. Moreover, many of the countries involved are likely to produce less than their commitments in the second quarter of 2020 any way, invoking force majeure in some cases for not being able to fulfill commitments.
Goldman Sachs is more sceptical. Assuming full compliance from OPEC and 50% compliance by other participants in May this could lead to an actual -4.3mb/d reduction in production from first quarter 2020 levels, on the broker’s assessment.
Hence, given the difficulty for most producers outside of the core OPEC group to implement large cuts, the agreement is too little too late in order to avoid breaching storage capacity.
Storage
Shaw assesses inventory will increase until incremental production is lower than demand, which is not on the short-term horizon. Assuming oil markets remain oversupplied for at least three months by 20mb/d, inventory is likely to rise by 600m/bbl per month. On this basis, the broker calculates, by late May or early June physical storage limits will have been reached.
Canaccord Genuity agrees that, even if the co-ordinated cuts amount to President Trump’s assessment of -20mb/d, it will be difficult to prevent the market being oversupplied in the near term.
Goldman Sachs does not believe oil purchases by the IEA will change the supply/demand balance and estimates combined commercial and government storage capacity will be reached by late April. Any upside surprise therefore would need to come from China, where there is little visibility on storage capacity.
Goldman Sachs reiterates the view that inland crude prices will decline further in coming weeks as storage becomes more difficult. Downside risks to the broker’s short-term US$20/bbl forecasts are envisaged.
The reduction in seaborne exports is likely to lead to Brent outperforming, Citi points out, as the cuts will ease the drag on global fleet transport, freeing vessels for floating storage and capping freight rates.
Pricing
While the production cuts are welcome, Citi believes they may do little more than affect market psychology in the June quarter and will not prevent prices from sliding, on average.
Storage is expected to be inadequate and prices will have to drop to levels that are low enough to force production to cease, at least for several days to below US$20/bbl, and even US$10/bbl, in Citi’s view, to balance supply and demand. However, the market should rebalance in the third quarter and demand start to rebound, supporting prices for the rest of the year.
ANZ analysts expect the production cuts will support prices in the short term and reduce the risk these drop into the “teens”. Still, any rally is likely to be relatively short lived as oil inventory will probably rise in coming months.
With a cut of -9.7mb/d and up to -5mb/d estimated from other countries, Goldman Sachs assesses this is too little to stop an oil price collapse. Ultimately, the broker believes, no voluntary reductions could be large enough to offset the -19mb/d average April-May loss of demand because of the pandemic.
