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Oil: Lower For Longer Is The New Normal Amid A Slumping Global Economy

Russian President Vladimir Putin.

Russian President Vladimir Putin attends a meeting on the situation of global energy markets via … [+] teleconference call at the Novo-Ogaryovo state residence outside Moscow, Russia, Friday, April 3, 2020. Vladimir Putin says he supports cutting oil production by about 10 million barrels a day to shore up falling oil prices.

Alexei Druzhinin, Sputnik, Kremlin Pool Photo via AP

Oil prices managed to recover some ground over the past few trading sessions, but they’re still well below where they started the year. The oil market is on life support after getting hit by both demand and supply shocks.

Since the COVID-19 outbreak emerged from China, the global oil market has been experiencing a massive demand shock that saw the need for transportation fuels fall dramatically as lockdowns spread across Asia, the U.S. and elsewhere. 

COVID-19 decimated oil demand by shutting down much of China’s economy activity, which had accounted for 35% of global GDP growth, and basically brought an abrupt stop to global air traffic, reduced automobile traffic as much as 50% in many markets and economies around the world.

At the same time, Saudi Arabia and Russia engaged in a price war for market share, resulting in a sizable supply shock. The Organization of Petroleum Exporting Countries, Russia and other producers, a group known as OPEC+, has reached an unprecedented deal to withdraw about 10% of the global supply, but it already looks like too little, too late.

Demand may have fallen by as much as 30% and the world is possibly just weeks away from running out of storage space for all of the surplus oil. Producers are literally paying traders to take the commodity off their hands as oil prices turn negative.

In a physical commodity market, oversupply will always outweigh the soundbites and pronouncements of government officials seeking to talk up prices. Talk is cheap in a physical market like oil.

The storage tanks are full, everything is full, there’s no place to put the oil, which led to this farcical circumstance where the price of something which is necessary for the way we live, went in fact, subzero.

For the 1st time in history OIL for delivery is finding its “clearing price” at ZERO. The price went negative this week, signaling that there is no place to store all the crude the world is producing and not using.

This is an oil crisis unlike any other, and as things deteriorate, the unsavory side of geopolitics will likely emerge as the recent spat between (MBS) Mohammad bin Salman Al Saud Crown Prince of Saudi Arabia and Russian President Vladimir Putin clearly showed.

Saudi Arabia's Crown Prince Mohammed bin Salman

Saudi Arabia’s Crown Prince Mohammed bin Salman attends a meeting with the U.S. secretary of state … [+] in Jeddah, Saudi Arabia, on September 18, 2019.

MANDEL NGAN/AFP via Getty Images

More than other countries, Russia faces the shock to global oil prices from a position of strength, but the test will be domestic trust in the macro framework in place since 2014.

According to the U.S. Energy Information Administration database, Russia is the third-largest oil producer in the world, only surpassed by the United States and Saudi Arabia. According to Moody’s, the most vulnerable oil producers in terms of credit profiles are led by Gulf Cooperation Council (GCC) members Oman and Bahrain.

Global oil demand will plunge a record 9.3 million barrels a day in 2020, wiping out a decade of consumption growth, according to the IEA (International Energy Agency).

The IMF said the global economy is expected to shrink by 3% this year. The economies of Asia’s largest trading partners are expected to experience deep contractions: The U.S. is projected to shrink by 5.9%, while the euro area as a whole is forecast to contract 7.5%.

China is one of the few economies poised to grow in 2020, according to the fund’s projections. But the IMF’s 1.2% growth forecast for the country is a sharp slowdown from China’s economic performance in previous years.

So no matter what further actions OPEC+ takes, the world is heading for an enormously oversupplied market and a period of sharply lower oil prices. How quickly oil prices recover is largely a function of the trajectory of the virus and the mitigation measures needed to contain it.

The current unprecedented oil demand shock and associated price collapse could ultimately create a large negative oil supply shock and rapid price increase. The violent nature of this process, will permanently alter the global energy industry and its geopolitics, create inflationary pressures as economic activity normalizes post-coronavirus lockdowns and shift the debate around climate change.

With the outlook for COVID-19 related shutdowns globally still extremely uncertain there is no clear end in sight for low oil prices. The big takeaway on the oil market is that there is a physical component to this market. Oil is not like the stock market, this is not a confidence market.

Illustrating this is the price divergence between the two benchmarks of Brent and WTI (West Texas Intermediate) also known as Texas light sweet which is attributed to storage dynamics.

Brent crude is priced in the middle of the North Sea, where tanker storage is ample and accessible, while WTI oil storage in the U.S. is limited as well as landlocked, making transportation relatively more difficult. As a result, Brent is more removed from the coronavirus demand shock and WTI prices are much more sensitive to that shock, as demand drops, storage fills up and prices fall.

Negative oil prices like those reached for the first time in history on April 20th will force oil producers to leave it in the ground. Oil producers need demand above supply for inventories to draw and prices to discover.

According to the International Energy Agency the total cost of producing a barrel of oil, which includes finding cost, prior year write-downs, cost of capital, and social rents like taxes, is between $50 and $60 per barrel. The oil industry cannot continue to produce a product for less than its cost of capital, the oil industry will be self-liquidating and is in fact, self-liquidating.

In the final analysis, the cure for low prices is low prices. In the meantime, however, there is low potential for a V-shaped recovery in energy demand, especially as we expect to see more of an L-shaped recovery in global equities. Lower for longer is the new normal for oil.

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