Could 2021 Bring Another Oil Price Crash?
“Just when everyone thought the oil market was finding its footing, along comes a unilateral production cut from Saudi Arabia. Does this reflect cracks in the unity that has governed the oil market, or more sinister motives?”
The oil price forecasts for 2021 are rolling out, with virtually everyone expecting prices to go higher. The “bullish” 2021 views reflect the dismal average oil price recorded for 2020. The low price was helped by the crash to a negative $40 a barrel for the West Texas Intermediate (WTI) May 2020 futures contract on April 19, even though the price snapped back to about $20 a barrel almost immediately. That was the first time ever for oil prices to trade at negative prices. To demonstrate how bad the oil market was, on the day the May contract fell into negative territory, the following month’s (June) contract price was barely over $20 a barrel representing the largest spread in monthly contract values ever. To say last spring was an extraordinary time for crude oil would be an understatement.
To refresh memories, the price crash was caused by the unprecedented collapse in oil demand due to the economic shutdowns mandated by governments around the world in response to fighting the Covid-19 pandemic. The problem was that the oil industry cannot stop production as rapidly as demand can collapse. The logistical structure of the global oil industry works on yearly or monthly time-tables, not weekly or daily ones. We see this often when storms disrupt normal life and consumers stop using oil products literally on a dime. The logistical issue highlighted another oil industry challenge, which was the amount of oil storage space available at Cushing, Oklahoma, the main pricing point for WTI. Even today, oil traders are questioning whether WTI should remain the primary oil price marker, given its structural issues. With growing oil exports, oil pricing on the Gulf Coast is becoming a more important driver of industry actions than WTI.
Exhibit 1. Saudi Arabia And OPEC Helping Oil Recover SOURCE: EIA, PPHB
Despite all the gnashing of teeth over the relevancy of WTI (much like Brent on the world stage), one can view it much like how the Dow Jones Industrial Index (DJIA) is viewed by people. Although it no longer reflects the structure of the U.S. economy, its long history provides a perspective for people to judge current movements. An historic relic? Maybe. But it is an easy way to assess conditions.
Last spring, as oil prices crashed, a market standoff began among the three major suppliers – the United States, Russia and Saudi Arabia, representing OPEC – that appeared intractable. The oil price collapse sent U.S. producers scurrying to find storage for their flowing output, while also attempting to choke off production and get out of supply agreements with refiners who no longer needed the oil. The high point of frustration was the day-long hearing by the Texas Railroad Commission (TRC) over whether it should reinstitute pro-rationing in the state’s oil fields to help control the overproduction of crude oil relative to demand. Big producers, small producers, royalty owners, oilfield service companies, academics and consultants, and even politicians representing educational interests in royalty payments all weighed in. The conclusion was that as much as everyone thought the TRC could resurrect its 1930s success in controlling overproduction of crude oil in Texas, the state now accounts for a much smaller portion of U.S. output, making its efforts potentially destructive for local operators who would lose market share, while failing to see prices rise. In such a situation, Texas oil producers and the TRC commissioners were caught between the proverbial “devil and the deep blue sea.”
As America struggled to figure out what it could do to help reduce the oil oversupply of oil that was killing prices, OPEC, led by Saudi Arabia, was wrestling with its new partner – Russia – over what it should do about output. Everyone was being hurt by collapsing oil prices, but some countries were faring better than others, so those less impacted were not in a rush to cut output and choke off their income, although it was shrinking rapidly. U.S. President Donald J. Trump jumped in and began an international mediation effort to get Russia and Saudi Arabia (OPEC) to agree to an historic cut.
A month earlier, Saudi Arabia proposed a cut of 1.5 million barrels per day (mmb/d) to combat weak demand, but Russia rejected it. This set off a price war, with Saudi Arabia cutting oil prices to its customers in Asia, while also announcing plans to boost production to 12 mmb/d in order to increase exports. Russia also planned to lift its exports and match Saudi’s oil price cut. This was the oil landscape as Covid-19 was crushing demand and oil prices. By engaging both Russian President Vladimir Putin and Crown Prince Mohammed bin Salman, President Trump facilitated a compromise that led to a 10 mmb/d production cut. Since it had been rumored that the agreement could be as large as a 15-20 mmb/d cut, the announced agreement was met with disappointment and falling oil prices, although they began to recover shortly thereafter.
The OPEC+ agreement called for a 10 mmb/d cut for May and June, and then for it to taper off to 8 mmb/d for the remainder of 2020. Beginning in January 2021, the cut would be reduced to 6 mmb/d, which would continue until 2022, if not reduced further during 2H21. As we approached year-end and Covid-19 staged another global outbreak that forced governments to reinstitute economic lockdowns, OPEC+ debated the fate of the 2 mmb/d supply restoration programmed in the April 2020 agreement. With Russia wanting to push forward, but Saudi Arabia worried about another oil glut dropping prices, a compromise was reached. It called for adding 500,000 barrels per day (b/d) in January, and for the OPEC market monitoring group to meet monthly and determine when to add more supply to the group’s output.
This is where we were as 2021 opened. After the first day of meetings, the group failed to reach an agreement about February’s supply. The second day’s discussions produced an agreement to hold supply steady for February and March before considering adding another 500,000 b/d to supply. While Russia argued that world oil demand would quickly return as the vaccine was rolled out, Saudi Arabia was more concerned that the recent re-implementation of economic lockdowns and the slower rollout of the vaccine would depress the demand recovery. Based on how quickly the two sides reached their agreement, one is left with the feeling that Russia was less confident in its argument than Saudi Arabia was in its. The market’s reaction was swift with WTI passing $50 a barrel for the first time since February 2020, before slipping slightly under that mark. Brent crude oil nearly reached $53/b, the highest price it has attained since late February 2020.
Then, Saudi Arabia unilaterally announced a 1 mmb/d production cut. Saudi officials said that Russia was aware of the planned move when their production agreement was announced. The move raises many questions. Answers will only become clear in the future. Did the cut reflect Saudi’s concern about Russia abandoning the OPEC+ group? That would have precipitated another oil war, something that would devastate all producers. Maybe Saudi Arabia is much more concerned about oil demand in early 2021, or possibly long-term. Is it possible there are concerns about the sustainability of Saudi production after having produced at such a high rate for a long time? Could the kingdom have progressed in developing alternative energy sources such that it doesn’t need to burn as much oil to generate electricity?
The oil market is treacherous. As OPEC+ navigates the market during 2021 – at least in the early months – it has to gauge the actions of American oil producers who are motivated by oil prices and their own profitability. On the other hand, Russia and OPEC can control its supply better because there are fewer major swing producers. What neither Russia or Saudi Arabia, let alone anyone else, knows is how much lower American oil producers’ breakeven levels are today versus a couple of years ago. Last year’s disastrous oil pricing environment forced companies to cut staff, negotiate lower service costs, restructure balance sheets, all in an effort to lower breakeven prices to generate profits in a world of low- to mid-$40s per barrel prices. Late in the year, with oil prices between $45 and $50, many producers were announcing that they were starting to generate positive cash flows. If that is truly the new world for American oil producers, they will become an anchor against substantially higher oil prices in 2021.
An interesting question is whether oil at $50 marks a new ceiling or floor? We will only know the answer in hindsight, but depending on how producers view the answer to that question may dictate how rapidly the drilling rig count rebounds.
Overhanging the pricing dilemma for oil companies is the fate of crude oil in a world increasingly racing toward net-zero carbon emissions. The oil-pricing turmoil of the past five years has upset the measured pace of exploration and development for new oil reserves. The argument for substantially higher oil prices in the future rests on the assumption that developing these new supplies requires much higher than current oil prices. Defining “much higher” is impossible because we don’t know how much additional oil supply will be needed due to the unsettled long-term demand outlook, as a result of Covid-19 behavioral changes, the rate of population vaccinations, and the pace of the transition to renewable energy. The world’s major oil exporters are walking through a field of mines where any misstep could send oil prices crashing. Clarity on demand will not improve until this spring, and even then, confidence about future oil demand will remain tenuous. Even though the outlook will improve, it will remain cloudy.
This year should be a better year for the oil and gas industry than 2020. How much better is impossible to predict now, but the fundamentals support healthy oil prices and increased demand with somewhat limited supply growth. However, geopolitics, greed and Black Swans are always lurking around this industry. An interesting tid-bit is that 2021 is the Year of the Ox in the Chinese zodiac. We noted the list of prior Ox years: 1925, 1937, 1949, 1961, 1973, 1985, 1997, and 2009. Three of those years – 1973, 1985 and 1997 – marked pivotal times for the global oil market. Each of the Arab Oil Embargo, the OPEC price war and the OPEC Asian oil output misstep contributed to significant changes in the then current direction of the industry. Importantly, none of the events were anticipated. Will there be a surprise in 2021? What might the surprise be? We’d just as soon pass on the drama, but the fates will not allow that to happen. Let’s hope we can avoid missteps to the downside, and that 2021 marks the start of an extended positive cycle for the oil business. Wouldn’t that be a surprise!