Will the oil market plunge sink all producers?

The bloodbath witnessed by the crude oil market on the weekend of March 08, a ‘seismic’ event of sorts, saw oil prices nosedive to record lows. First, on Friday, March 6, news came in that talks between OPEC and select non-OPEC countries led by Russia for the extension of production cuts had collapsed; this implied that all producers would be free from April 1 to pump as much oil as they could. The likely result would be an oversupply in a market already grappling with slowdown in demand following the outbreak of coronavirus. Second, on Saturday, March 7, there was news of Saudi Arabia offering discounted prices to customers in line with its aggressive strategy to increase market share. This could potentially prompt producers across markets to cut prices in their bid to garner a bigger share. The overall impact was a mayhem in oil prices that led major research houses to substantially revise price targets downward. The developments may have far reaching negative impact, albeit in varying degrees, on all oil producers, from GCC countries to Russia to US shale oil producers.

Why the talks failed
OPEC and select non-OPEC producers led by Russia had to a large extent successfully implemented self-imposed production cuts to rebalance the demand-supply gap since December 2018. The agreement to cut production by up to 1.2 million barrels of oil per day agreed in Q4 2018 rather took markets by surprise. Even Saudi Arabia decreased production by more than its quota, as it looked to take the lead and set an example for other producers to follow. As a result, oil prices recovered from the bear phase reached in early Q4 2018. Throughout 2019, subsequent similar decisions by the OPEC+ group indicated its commitment to address the demand-supply imbalance, as some of the biggest consuming economies, such as China and India, witnessed a slowdown. The recovery in oil prices also helped Saudi Aramco IPO sail through in Q4 2019.

Despite this, other developments had built pressure on the fragile arrangement between a wide group of oil producers. Saudi Arabia was unable to persuade Russia to completely comply with its share of production cuts, crucial for the OPEC+ group to implement its strategy. The US, not part of this group, kept on increasing production, led by private shale oil producers vis-à-vis the government controlled producers of Saudi Arabia and Russia. The US became the world’s largest producer in 2019, thus upending the strategy of OPEC+ producers to tilt the demand-supply imbalance in its favor. Furthermore, Russia had been affected due to several sanctions imposed by the US and European countries following its annexation of Ukraine’s Crimea province. In February 2020, the US imposed sanctions on Rosneft, the flagship oil and gas producer of Russia. Eventually, matters came to a head during the meeting on Friday, March 6—it was announced that producers were not bound by their early agreement to continue complying with production cuts.

Based on known production capacities as of date, Saudi Arabia can quickly increase production to 11 million barrels per day from less than 10 million barrels per day currently. Russia can also raise production by 130,000 barrels per day. Overall, a combined capacity of over 2 million barrels per day can be theoretically brought into play. The increased supply would end up being stored in facilities such as those in Fujairah, or in floating tankers. Barring any last-minute surprise deal being struck by the OPEC+ group or any subgroup or even US oil producers joining forces with OPEC+, the global supply glut will in all likelihood worsen.

Plunge, an indicator of dire circumstances
Prior to the week of March 6, oil prices were already under pressure as the Covid-19 virus spread, taking over 50 countries in its fold and showing no signs of abating. This evoked restrictions on travel, both international as well as domestic travel in certain countries such as China (province of Hubei) and Italy (northern region in particular). The restrictions, either imposed by governments or self-imposed by corporates and individuals, would mean lower demand for transportation and thereby fuel. The oil market had been closely watching the developments, trying to ascertain to what extent economic activity would be affected and for how long, as this would help assess when demand was likely to recover.

Even before any sign of recovery could appear, on Friday, March 6, oil prices started to fall, reflecting the impact of the OPEC+ group’s decision to not extend production cuts. Prices took further beating as Saudi Arabia decided to offer discounts to the range of USD 3–7 per barrel for various customers, besides rapidly increasing production, reaffirming its strategy to expand market share at any cost. Overall, the coronavirus spreading and OPEC+ talks failing delivered a ‘1-2’ knockout punch to the oil market, sending prices in a free fall.

Implications for GCC countries
All eyes will be on Saudi Arabia, which has acted decisively after the failure of OPEC+ talks, given its strategy. The favorable geological nature of reserves (shallow and easily extractable) also means that Saudi Arabia can increase production fairly quickly, flooding the market if it desires. This, coupled with its lowest cost of incremental production, would imply that Saudi Arabia stands to benefit the most if it is able to lock-in sale of incremental production. Nonetheless, the strategy would disturb its budget math for 2020. It could lead to lower-than-expected oil revenues and a wider fiscal deficit, unless KSA decides to curtail expenditure and risk another economic slowdown, similar to the one in 2017. With its large forex reserves, Saudi Arabia also has the capacity to pursue this strategy for a longer period than some of its GCC neighbors. The extent to which Saudi Arabia will be affected would be determined by the volumes being sold and how low oil prices may go; arriving at a reasonable estimate is, therefore, quite difficult. All eyes will now be on the Q2 2020 budget statement (since Q1 2020 had two months of stable production and oil prices) report to assess the extent of damage. Consequently, we may see credit rating agencies putting Saudi Arabia’s rating on review or revising it downward.

Rest of the GCC countries would undoubtedly be dragged into the imbroglio with no control over the outcome. Some of them like Bahrain and Oman are also fiscally vulnerable and any substantial fall in oil prices would bring their sovereign credit ratings on the radar of ratings agencies. For Qatar, a major producer of oil, prospects have been dwindling already due to the fall in gas prices that predated the decline in oil prices.

GCC markets, both equity and fixed income, already reacted to the developments on Sunday, March 8 (GCC markets function Sunday to Thursday). Aramco stock fell below its recent IPO price. The Saudi Arabian primary market, which was warming up after Aramco IPO that reintroduced Saudi Arabia to the global investment community, would definitely be impacted by the sentiment. On the fixed income side, spreads for new issuances will widen. CDS spreads for GCC countries have already widened and 10-year sovereign bond yields have worsened as a knee-jerk reaction.

Will Russia rue its decision to walk away from the OPEC+ group?
Russia, portrayed by the media as the perpetrator of the failure of talks to extend production cuts, may have to take a relook at its decision. If it is unable to increase volumes (due to weak demand following the virus epidemic that shows no signs of peaking yet), and worse, if it loses customers to Saudi Arabia or any other producer, the lower oil prices would hit its foreign income and worsen the fiscal situation. Russian equities, which did well in 2019 would suffer in the near term. However, the economy has withstood several rounds of sanctions over the years. Hence, it is uncertain to what extent the latest development would affect the economic sentiment vis-à-vis that in other producers.

US shale oil producers to take the highest impact
The US shale oil industry flourished in the last couple of decades as increase in production, made possible by technologies such as fracking and horizontal drilling, catapulted the US to the top position in oil production (on monthly basis) in 2019. However, growth was based on substantial leverage on balance sheets backed by oil reserves valued on the basis of oil prices and benefits arising from the low rate environment. Large portions of outstanding debt (up to USD 86 billion) are reported to be due for refinancing over the next four years until 2024, as per Moody’s. The dominance of oil producers in the high yield debt market can be gauged by the share of the energy sector (~11%) in high yield bond ETFs.

Low prices may not majorly impact producers in 2020 as prices would be locked in using options (similar to the scenario in 2015, when oil prices first crashed from USD 100 per barrel levels). However, the longer the low price environment prevails in 2020 and beyond, the more difficult it would be for oil producers to generate enough cashflows to service debt; this would increase the number of bankruptcies. Similarly, volumes in the high yield credit market would be impacted, as shale oil producers face challenges in refinancing debt with value of reserves declining amid lower oil prices.

The impact is bound to be felt on shale oil & gas sector, a booming segment of the US economy. The oil & gas sector has been driving the economies of states such as Texas, and consistently contributing to new job additions. Listed oil & gas companies alone are reported to employ 700,000 people, with many more being employed directly by unlisted companies and several indirectly dependent on the sector. While the US economy and employment market is large enough to withstand the slowdown in one sector, it would invariably be a drag on consumption and employment in the long term.

Likely beneficiaries – emerging market consumers and industries
The countries that stand to benefit the most from the fall in oil price are major oil importers, such as India and China, whose import bills would decline. India, where domestic fuel prices are linked to international prices, the imported fuel price inflation component would decrease, resulting in better margins for companies having fuel as one of its major costs. However, it is uncertain if the decline in fuel prices will be enough to offset the subdued sentiment among consumers and corporates affected by structural and cyclical factors of slowdown. Even for industries such as airlines that have incurred substantial losses due to travel restrictions on account of Covid-19, the lower aviation fuel costs would only provide a partial relief.

Conclusion
The events between March 6 and 7 may have a far reaching impact on the main stakeholders – oil producers and their economies. Various parties may be affected in varying degrees. In some, such as oil markets, GCC equity and fixed income markets, as well as US high yield market, the result will be immediate. On the other hand, for GCC economies, Russia and US shale oil producers, the effects would become clear over long term. The immediate positive impact, however, would be if producers return to the negotiating table now that markets have reacted sharply to the developments.