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OPEC Pours Oil On Coronavirus Part 1

Commodities | Mar 10 2020

Where will the latest stoush among major oil producing companies land the global economy as the spread of coronavirus interrupts trade and frightens markets?

-Oil price slump exacerbates the widening of credit spreads
-Is the action by Russia, Saudi Arabia targeting US shale?
-When is Brent oil likely to bottom?

 

By Eva Brocklehurst

As the spread of coronavirus provided the ammunition, all it required to panic the market was a trigger, and OPEC (Organisation of Petroleum Exporting Countries) and Russia provided one on Friday.

Saudi Arabia had indicated it would not sanction a continuation of agreed production cuts if Russia wouldn't come to the party. And Russia refused. The current deal among OPEC members expires at the end of March and with no agreement, global oil production is likely to ramp up.

This comes at a point in time where airlines, some of the largest consumers of oil, are cutting back on capacity. Air New Zealand ((AIZ)) has withdrawn its profit guidance for FY20 based on cancellations and reduced forward bookings. UBS notes Air New Zealand is not alone, as a number of US airlines have withdrawn earnings guidance over the last few days.

Meanwhile, Saudi Arabia has reduced crude oil pricing by the largest amount in more than 30 years which affects around 14m b/d of global oil supply, as the price from other Gulf nations are tied to Saudi Arabia's price. Saudi Arabia intends to boost oil output to 10m b/d in April.

Rosneft, Russia's state producer may also potentially increase production by 300,000 b/d from April 1.To augment its stance, Russia has stated that it it has enough reserves to endure oil prices of US$25-30/bbl for "6 to 10 years".

Falling crude prices may be considered a stimulus when economies are sound and consumer intentions healthy, but Citi points out there are other issues making this complicated in the current scenario.

As oil prices have fallen, inflation expectations have dropped further and this may be pointing to recession, the broker adds. Declines in household wealth as a consequence of the drop in equity prices could restrain consumption patterns at the upper end of the market. Up for consideration too are the supply disruptions to western factories as inputs are not being shipped from Asia because of coronavirus.

The slump in oil prices exacerbates the widening of credit spreads and financial institutions could need to tighten lending standards even further. To the broker, credit-related drags could partially explain the price action in banks to date. Citi would become more worried if credit spreads widen out further and the cost of capital climbs.

The availability of credit for small business is the issue to watch in this regard, as there has been little stress exhibited to date.

Why dump oil on a market where demand is precarious?

Several analysts, including Commonwealth Bank, suggest Russia's reluctance to cut output may have more to do with the US shale oil sector, given the profitability issues that it faces. Russia is also unimpressed with US sanctions on its trading arm and attempts to halt a gas pipeline to Germany. Citi believes Russia is aiming at US shale and Saudi Arabia's decision to cut prices savagely is aimed largely at Russia, although this could also impact shale significantly.

Commonwealth Bank analysts note Saudi Arabia embarked on a similar strategy at the end of 2014, intending to drive higher-cost US shale producers from the market. Brent crude eventually settled in 2016 at under US$30/bbl.

However, 2020 may be different, given the shock oil markets are facing from coronavirus. The International Energy Agency expects global oil consumption to fall -90,000 b/d in 2020. Jet fuel and road transport demand other key areas where the virus is expected to have a significant impact on demand.

Coronavirus has reduced global growth to the weakest levels since the GFC, Citi asserts. The number of new cases in China may be slowing but they are rising in the US and Europe. This could result in demand shock outside of China. China's economy could benefit from lower energy costs, being a net crude importer, but lower crude prices are weakening the US dollar, Citi points out, which reduces China's competitiveness in export markets.

Where Could The Price Go?

Brent oil prices are now down -50% over the year to date. Macquarie forecasts a US$60/bbl average price for the next two years. Canaccord Genuity lowers forecasts for 2020 oil prices to US$45/bbl. The broker acknowledges some may consider this short-term forecast overly bullish but highlights that a number of major oil producing nations are unable to balance budgets at these levels.

Commonwealth Bank analysts expect Brent oil will now likely bottom in the US$20/bbl range during the next quarter before slowly recovering to US$60/bbl by the end of 2021. This is predicated on demand recovering as coronavirus eases, amid no new near-term production limits among oil producers.

Part 2 to follow.

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