oil output cut deal: Crude oil outlook bleak despite record production cut by Opec++

Crude oil prices were highly volatile last week in anticipation of an Opec+ deal. On Sunday night the oil producers’ group agreed to a plan to slash production by 9.7 million barrels per day from May, ending the price war between Saudi Arabia and Russia.

The agreement followed four days of intense negotiations after Mexico declined to endorse the original agreement. The deal is a little less than the market expected given that Mexico has gotten off easy. The market is very sceptical that Opec+ is actually going to be able to come up with their near 10 Mbpd of production cuts.

The production restraints are set to last for about two years, though not at the same level as the initial two months. Copying the model adopted by central banks to taper off their bond buying, Opec will also reduce the size of the cuts during the course of two years. After June, the 10 Mbpd cut will be tapered to 7.6 Mbpd until end of the year, and then to 5.6 Mbpd through 2021 until April 2022.

In the US, the huge jump in jobless claims was overshadowed by a series of new Fed programs, including one that will buy junk debt and another that will offer four year loans at 2.5-4 per cent for ‘main street’ firms with less than 10,000 employees and $2.5 billion in annual revenue. The announcement gave a small lift to risk trades, but was a big anchor on the dollar.

Opec deal
Russia has reportedly agreed to slash output by 2 Mbpd, while Saudi Arabia will cut four million bpd from its record-setting April production levels of 12.3 Mbpd. That’s a cap of 8.3 Mbpd, with both expected to bring down their respective production to around 8.5 Mbpd.

The US, Brazil and Canada will contribute another 3.7 Mbpd on paper, as their production declines and other G20 countries will cut an additional 1.3 Mbpd. The G20 doesn’t represent real voluntary cuts, but rather reflect the impact that low prices have already had on output and would take months, perhaps more than a year to occur.

Mexico will reduce output by 100,000 bpd and rejected its 400,000 bpd share of original deal and the exception granted to Mexico may drive cracks through Opec+. Now its future inside Opec+ is uncertain, as it’s expected to decide over the next two months whether to leave the alliance. The lack of formal contribution from Non-Opec nations such as Canada, Norway and Brazil is also disappointing. The market is sceptical on compliance and there will be a lot of scrutiny on oil producing nations. For the last two decades, Mexico has bought so-called Asian style put options from a small group of investment banks and oil companies, in what’s considered Wall Street’s largest and most closely guarded annual oil deal.

The options give Mexico right to sell its oil at predetermined price. They are equivalent of insurance policy: the country’s banks gain from higher prices, but enjoy the security of a minimum floor. So if oil prices remain weak or plunge even further, Mexico will still book higher prices.

The hedge isn’t the only reason Mexico is holding out. But it strengthens country’s hand and makes it less desperate for a deal than countries whose budgets have been ravaged by the collapse in oil prices since the start of the year, first because of the coronavirus and then because of the price war launched by Saudi Arabia.

In US, where the legislation makes it hard to act in tandem with cartels reported that output will fall steeply by itself this year due to low prices. US Secretary of Energy Dan Brouillette reported that US was already on track for a production decline of 2-3 Mbpd. Further, he underlined that the country is taking action to open strategic petroleum reserves to store as much oil as possible. This will take surplus oil off the market at a time when commercial storage is filling up and the market is oversupplied.

Despite Opec+ reaching an agreement to reduce crude production and effectively stopping the price war, oil prices still fell. Countries are leaking big money — for instance, estimates put Russia is losing some $100 million a day from not reaching an agreement to cut crude production sooner.

But even if producing countries fulfil their commitments to cut output, would that be enough to stem the crude oil oversupply and the resulting impact on prices?

Global oil consumption is down by at least 25 per cent and could have gone beyond 30 per cent without intervention. That’s equivalent to 30 million bpd.

So what impact could an optimal output cut of 10 million to 15 million bpd make? The deal doesn’t take effect until May 1, leaving Opec+ countries, which have significantly increased production over the last month, able to continue flooding the market for nearly another three weeks.

Storage woes
The Middle East’s main oil-trading hub has run out of room to store unwanted barrels. Terminal operators at Fujairah in the United Arab Emirates say they’re turning down requests from traders and refiners to store crude and refined products, whereas a year ago they had ample space. Demand for storage, an unglamorous, but essential link in global energy supply chain, is at its highest in years. With oil prices on the floor, building up reserves makes sense anyway, and China and India have already started. But storage space is limited. Oil traders estimate that China could buy an extra 80 million to 100 million barrels this year. Meanwhile, India is asking state-run refiners to buy 15 million barrels of crude from Saudi Arabia, the United Arab Emirates and Iraq to fill its tanks. Beyond those three countries, there’s little storage capacity elsewhere.

Diplomatic win
The biggest winner appears to be US President Donald Trump, who refused to actively cut American oil production and personally brokered the deal over phone calls with Mexican President Andres Manuel Lopez Obrador, Russian President Vladimir Putin and King Salman of Saudi Arabia.

With the virus paralysing air and ground travel, demand for gasoline, jet-fuel and diesel is collapsing. That threatened the future of the US shale industry, the stability of oil-dependent states and squeezed the flow of petrodollars through an ailing global economy. Ultimately, this looks like a great political move that will shield Opec and Russia from further criticism. They cut by 22 per cent and until the rest of the world does the same, oil prices are now their problem.

Will the deal fix the market?

This deal fails to address the oversupply issue and these kinds of cuts will need to be in place for months if not a year to come anywhere close to solving the problem. The crude outlook continues to be bleak, despite the unprecedented production cuts.

Scale of demand destruction in the immediate term is too big for anyone to manage. Rather, the deal should be viewed as limiting the damage – in terms of bloated inventories – and allowing the market to stage a modest recovery.

Global oil inventories will still increase by more than 730 million barrels this year, rising roughly 8 per cent above last August’s record 9 billion bbl. The cuts basically aim to prevent even larger inventory build up, which could otherwise hang over market and depress prices for another two years.

This week’s deal could in theory drain that inventory build by mid-2021, although this would require a strong rebound in demand growth and pretty strict compliance with the deal. Another year of market pressure seems likely, but things would have been much worse without this agreement – with prices likely diving to single digits near-term. Opec and other producers are playing a long game and Opec+ must have confidence that the US and others would do their bit.

(Investors are advised to consult financial advisers before taking an investment calls based on these observations)