Crude Market Research in April 2020
April 11, 2020
TABLE OF CONTENTS
1/ INTERESTS CONFLICT AMONG OIL-PRODUCING COUNTRIES
2/ OIL STORAGE SPACE GAME
3/ RUSSIA JOINS FORCES WITH SAUDI ARABIA AGAINST THE US
4/ MARKET OUTLOOK
5/ APPENDIX 1 – WORLD OIL MARKETS INTRODUCTION?
6/ APPENDIX 2 – SHALE OIL VS. CONVENTIONAL OIL
INTERESTS CONFLICT AMONG OIL-PRODUCING COUNTRIES
Market Review
On April 1st, in the morning in the US, crude oil suddenly experienced a sharp surge. The main reason was the stimulation from a piece of news: Trump and Putin discussed oil prices over the phone and reached a consensus that the current oil prices did not align with the interests of both parties. However, another piece of news immediately reversed the situation: Saudi Aramco announced it would increase production to 12 million barrels daily starting tomorrow.
From the initial breakdown of talks between Saudi Arabia and Russia, increased production, and oil price collapse, to pressuring the United States to enter the market, all this happened within just one month. Coupled with the impact of the COVID-19 pandemic on oil demand, it heightened the intensity and speed of the oil price decline and the urgency of this game.
Historical Disputes?
Saudi Arabia's dissatisfaction with Russia has a long history. Since the formation of the OPEC+ alliance between Saudi Arabia and Russia in 2016 to cut production, Saudi Arabia has been shouldering the main responsibility for production cuts. Therefore, Saudi Arabia has been a "loser" since the joint production cuts with Russia in 2016 as its market share has been continuously shrinking. On the other hand, Russia can be considered a beneficiary of the production cuts because its condensate oil (a different variety from crude oil that exists underground in gas form) is also included in the production cut quota. On the surface, Russia joined hands with Saudi Arabia in production cuts, but it only reduced condensate oil production while increasing crude oil production.
Saudi Arabia significantly increased its oil production from 9.7 million barrels per day in February to 12 million barrels per day. However, as the prices fell below breakeven, Saudi Arabia's oil revenue decreased while costs increased due to the production increase. Although sacrificing revenue helps Saudi Arabia regain a certain international market share in the short term, Russia's crude oil exports are mostly based on long-term agreements and rely on pipeline transportation. It is difficult for Saudi Arabia to directly seize Russia's market share through a price war, let alone completely drive Russia's production capacity out of the market.
Furthermore, to maintain fiscal balance, Saudi Arabia needs oil prices to be as high as $83.6 per barrel, while Russia only needs $42.4 per barrel. Therefore, after the breakdown of the production cut negotiations on March 6th, Russia claimed that it could withstand oil prices at the level of $25-30 per barrel for 6-10 years. Russia's national wealth fund exceeds $150 billion and can be utilized in a situation of long-term low oil prices. After all, from 2006 to the present, Russia has maintained a current account surplus every quarter for more than a decade, so it is indeed not a problem.
Cost Analysis
After the formation of OPEC+ with Saudi Arabia and Russia, the biggest beneficiary was the United States, which did not participate in any production cuts. In 2018, the United States surpassed Saudi Arabia and Russia, becoming the world's largest crude oil producer. Once the oil price war started, the most vulnerable were the US shale oil producers. Currently, US shale oil companies need an oil price of over $48 to break even on their comprehensive production costs, while the comprehensive production cost of onshore oil production in Russia is only $17-20, and Saudi Arabia only needs $10. If the oil price remains below $48 for a long period, many US shale oil producers will be forced to exit the market. Although the chain impact of the oil price decline takes some time to manifest, the urgency for the United States lies in the fact that shale oil companies' debts are expected to be the first problem to emerge. US shale oil producers have heavy debt burdens, and according to Moody's data, North American oil and gas companies face $200 billion in debt due in the next four years, with $40 billion due in 2020 alone. This partially explains why the Federal Reserve quickly implemented "unlimited, bottomless" QE measures. In addition to the impact of COVID-19, the domino effect of low oil prices on the financial market is also one of the important factors considered by the Federal Reserve.
OIL STORAGE SPACE GAME
Current Situation of International Oil Storage Space?
Just as Saudi Arabia increased production, US Treasury Secretary Mnuchin announced that Congress was considering purchasing more oil reserves.
As the CEO of Canary Oil, the largest private company in the United States, stated:
"The crude oil market is facing the first-ever crisis of inventory depletion. The price of offshore storage space has skyrocketed by four times. Many crude oil pipeline transportation companies have notified oil producers to stop sending oil through pipelines and quickly shut down production. The inventory crisis will be the next shoe to drop, and the inventory issue in the short term will determine how much further oil prices will decline."
According to estimates from various oil research institutions and consulting companies, global crude oil demand in April declined by 15 to 22 million barrels per day. This is roughly equivalent to the total production capacity of Saudi Arabia and Russia. Therefore, although the long-term direction of the international oil market is a cooperation between Saudi Arabia, Russia, and the United States, during this period of significant demand gap - equivalent to "only one out of the three can remain" - the focus of the game is still on maximizing self-interest.
The focal point of this stage of the game will be oil storage space. Due to the impact of COVID-19, a large amount of surplus oil has flowed into storage space worldwide - since China first initiated measures to control the spread of the virus, shutting down many refineries. Currently, global storage space is less than a quarter of its capacity. However, this is the global average, and the situation is even more pressing in some countries. The oil storage space in Western Canada, for example, is now only able to accommodate a few days' worth of production. As a result, the price of Canadian oil is now cheaper than tap water. Crude oil in Wyoming, USA, is being sold at $1.25 per barrel.
Many analysts believe that due to the exhaustion of storage space, oil prices in certain regions at a certain point in time may become negative. This is mainly because once production in many oil fields is shut down, it will result in permanent closure and the permanent loss of initial fixed investments. Of course, doing so is a short-term loss in exchange for long-term survival, hoping that other producers will die first and waiting for the spring of demand recovery. While Saudi Arabia, Russia, and the United States engage in a "do-or-die battle" in the next three months, many small producing countries will be the first to suffer heavy casualties, laying the foundation for a possible tripartite monopoly in the future.
For example, in the oil-producing regions of western Canada, production capacity has already been reduced by 400,000 barrels per day in March. Many oil wells and companies have been permanently shut down, rather than temporarily.
Storage Space Situation of the Three Major Oil-producing Countries
However, in terms of storage space on this battlefield, the three major countries still have relatively large maneuvering space.
Firstly, Saudi Arabia and Russia have centralized organization and control of their production capacity, which gives them greater "tolerance" compared to the scattered private oil companies in the United States. However, the United States is currently discussing plans to assist oil companies and storage. This disadvantage is expected to be reversed. In terms of the maneuvering space of storage among the three major countries, there are currently about 7.2 billion barrels of crude oil and oil products stored in storage facilities worldwide, of which about 1.3-1.4 billion barrels are stored in oil tankers at sea. At the current rate of storage, it is estimated that it will take up to 9 months to fill every inch of global storage space. However, extensive shutdowns and closures will inevitably occur in local storage facilities due to their full capacity, especially for inland oil wells.
In this regard, Saudi Arabia has its unique advantages. Its crude oil is mainly transported by sea. Saudi Arabia has already anticipated this and actively "prepared" by ordering and purchasing many giant oil tankers.
Although most of Russia's production and transportation capacity is on land, and its own storage space is limited, Russia's storage capacity depends on the space and consumption capacity of its long-term partners. From this perspective, Russia also has a relatively high "tolerance".
Data from the United States is the most "transparent": the utilization rate of the country's onshore storage facilities is currently only 50%. However, if the rate of storage at 2 million barrels per day continues, it will take about two and a half to three months to fill the storage space - it is expected that global demand will significantly recover after July. Another advantage for the United States is that a large portion of its production capacity comes from shale oil, which can be shut down at lower costs. However, pressure on the United States has already begun to manifest: the storage price of crude oil at the delivery point of the WTI crude oil futures, Cushing, has soared in a short period, reflecting the saturation of crude oil inventories at Cushing, which has an inverse relationship with WTI crude oil futures.
Arbitrage Opportunities
Looking at the current market contango structure of crude oil, traders buy low-priced physical crude oil and sell it at a high price to the futures market as delivery for forward contracts, thus locking in profits. This business is virtually risk-free. More specifically, before the significant rebound in crude oil prices last Thursday, traders were able to achieve profits as high as 20% on an annualized basis through this floating storage strategy.
The core logic lies in the fundamentals: the combination of the economic and travel stagnation caused by the pandemic and the price war among oil-producing countries has pushed supply and demand to opposite extremes. Excess supply is pouring into the market like seawater, and a place to store physical oil must be found. The contango structure will increase the demand for offshore storage. Unfortunately, at this time, onshore storage space is limited, which increases the demand for offshore oil tankers.
According to the introduction from Wu Yifan's team at Huachuang Securities, when the VLCC-TCE (equivalent time charter rate) is $30,000, $40,000, and $50,000 per day, respectively, there is an arbitrage opportunity when the price difference between three-month crude oil futures and spot prices exceeds $1.75, $2.2, and $2.65 per barrel. This time, the spread has reached an astonishingly high level. The Brent May contract was once as low as $13.45 per barrel compared to the November contract, and the WTI near-month and far-month contract spread also expanded to $12.85 per barrel, reaching the highest level since February 2009. Since the price war initiated by Saudi Arabia on March 9th, people have been rushing to charter oil tankers. The cost of chartering an oil tanker has multiplied several times, with prices ranging from $20,000 to $200,000 per day in March.
Even with storage costs skyrocketing to such high levels, hoarding oil can still generate substantial profits. Storing oil for six months can lock in profits of up to $7-8 million. Major trading companies are making every effort to participate, and Glencore is no exception. According to S&P Global Platts, the enthusiasm for chartering oil tankers has increased significantly in recent weeks, with up to 40 large oil tankers (VLCCs) and 20 Suezmax tankers already signing long-term contracts. Some tankers have lease terms of up to three years, setting a record in the industry.
Currently, global oil supply exceeds demand by up to 20 million barrels per day (according to estimates from the International Energy Agency), and oil tankers are filling up with crude oil at an unprecedented rate, almost five times that of the period of excess oil in 2015.
RUSSIA JOINS FORCES WITH SAUDI ARABIA AGAINST THE US
On April 2nd, Donald Trump personally made a phone call to the Saudi Crown Prince. Following the call, Trump publicly announced that Saudi Arabia and Russia had discussed and both sides wanted to reach an agreement on production cuts, potentially reducing production by over 10 million barrels per day. Trump himself hoped for a reduction of up to 15 million barrels. Upon hearing this, unaware of the truth, the oil prices experienced a rapid and wild "roller-coaster" ride, with Brent crude oil prices surging nearly 50%.
However, the oil prices quickly plummeted thereafter. If indeed the production cut of 10 million barrels per day were to happen, it would amount to 10-15% of global supply and would require Saudi Arabia and Russia to reduce their production by nearly 45%—an unprecedented scenario. Therefore, Trump's statement was likely an exaggeration. Subsequently, Russia firmly denied that Putin had a phone call with the Saudi Crown Prince, and OPEC representatives stated that Saudi Arabia and Russia had not reached any significant production cut agreement.
Regardless of whether a verbal agreement was reached, Trump's unusual oil diplomacy and his eagerness to declare victory reflect his growing anxiety about the US economy. If Saudi Arabia and Russia fail to reach a consensus on production cuts, Trump will find himself being left behind by the political strongmen, Crown Prince Mohammed and Putin.
The more Trump jumps and scrambles, the more it shows his desperation. This price war is a coordinated "pressure campaign" by Saudi Arabia and Russia, and it remains to be seen how Trump will respond under pressure.
OPEC representatives stated that a reduction of 10 million barrels per day in global oil production is a realistic goal and called for a meeting of oil-producing countries to reduce production. Saudi Arabia hopes that non-OPEC+ oil-producing countries will also participate in the meeting. "The US should join the new OPEC+ production cut agreement." When they refer to "non-OPEC+ oil-producing countries," it does not only mean Russia but also includes the United States, Canada, and Brazil. Some media reports suggest that only by having some major non-OPEC+ oil-producing countries join the production cut, Saudi Arabia will consider reducing its production to below 9 million barrels per day.
Essentially, Saudi Arabia is putting its cards on the table: dragging countries in the Americas into this and making them reduce production. This is the true intention behind this ongoing Saudi-Russian price war. Currently, Trump remains adamant, threatening to impose taxes on Saudi Arabia and Russia if they don't cut production. But as analyzed earlier, it is Trump who is least able to withstand low oil prices.
However, for Trump, the Saudi and Russian governments have strong control over domestic oil production capacity. They can increase or decrease production as they wish. Trump cannot do the same. Various oil companies, both big and small, along the supply chain in the US, have their interests. Even as the president, Trump does not have the power to force companies to reduce production. Coordinating the interests of all parties and coming up with a mutually acceptable production cut plan is as difficult as climbing Mount Everest. Furthermore, if Trump can present a production cut plan, it would be a significant concession to Saudi Arabia and Russia. At this critical juncture close to the elections, if the Democratic Party seizes on this issue, it could have a significant impact on the election results.
MARKET OUTLOOK
Review of this week's OPEC+ meeting
On Thursday, April 9th, OPEC+ held a highly anticipated production cut meeting, and the market experienced intense volatility during the meeting. However, what the market was left with after the OPEC+ meeting was even greater uncertainty.
The OPEC+ meeting on Thursday was a roller-coaster ride:
Please note that the figures of 11.3 million barrels per day and 23% are strange numbers that were likely negotiated on the spot. A reduction of approximately 23% is equivalent to a joint reduction of 5 million barrels, which means other OPEC countries would have to make sacrifices. By this point, the meeting had already been going on for most of the day, and the outcome would depend on whether the other 13 OPEC countries agreed and how the production quotas would be distributed. Additionally, it remained uncertain whether other G20 countries would cut production.
Thus, the OPEC+ meeting concluded amidst ups and downs, and the next meeting would not take place until June 10th. Furthermore, the agreed production cut of 10 million barrels per day by OPEC+ would only begin in May and cover the months of May and June.
The OPEC+ meeting on Thursday not only agreed to a reduction of 10 million barrels per day in May and June but also achieved an important strategic goal: completely shifting the responsibility to the United States. Previously, there were reports that Trump and members of Congress used military leverage to pressure Saudi Arabia, so the US side was very confident that Saudi Arabia would do everything possible to reach a production-cut agreement.
Saudi Arabia played its part well, stating, "Even if G20 countries do not join the production cut, OPEC+ will still cut production." On the one hand, they fulfilled the "assignment" of production cuts from the US, and on the other hand, they completely shifted the blame for future oil price drops to countries outside of OPEC+, especially the current world's largest oil producer, the United States. The outcome of the G20 Energy Ministers' meeting held on Friday would truly determine the direction of oil prices. With the estimated global oil overcapacity ranging from 20 to 35 million barrels per day, the OPEC+ production cut of 10 million barrels per day is insufficient.
Goldman Sachs holds a pessimistic view of the future:?
"Our models show that a reduction of 10 million barrels per day (considering recent substantial production increases, the actual reduction is only around 6.5 million barrels per day) is simply not enough. An additional 'natural reduction' (capacity closures due to price reasons) of 4 million barrels per day is needed to stabilize prices. This would require a total reduction of around 15 million barrels per day, which we believe is difficult to achieve."
G20 Energy Ministers' Meeting
The signals coming from the United States are indeed unfavorable for Friday's outcome: During the OPEC+ meeting, the US Energy Secretary explicitly stated that the US government does not have mechanisms to control oil production. The government is currently studying expanding strategic oil reserve capacity with Congress. It appears that the US does not intend to "proactively" cut production. As Trump also stated recently, the US will develop a "massive" storage capacity for oil.
In other words, it is unlikely that the United States will propose an "active" production cut plan in the G20 Energy Ministers' Meeting on Friday. As Goldman Sachs previously mentioned in a report, the US can point out that low oil prices have already led to a decline in production capacity, with the latest production capacity forecast by the US Energy Department decreasing by 2 million barrels per day compared to the previous month.
However, the US position is not set in stone. The largest oil-producing region in the US, Texas, is considering a coordinated production cut. Scott Sheffield, CEO of Pioneer Natural Resources Company based in Texas, recently disclosed that he and other oil company CEOs have proposed a coordinated production cut meeting with Texas regulators on April 14th. Texas has a production capacity of 5 million barrels per day, so a 20% reduction would amount to 1 million barrels per day. April 21st is a key date when the Texas regulators will make the final decision.
While the OPEC+ production cut meeting has temporarily ended, the uncertainties surrounding oil prices, including but not limited to the outcome of the G20 meeting, whether the US Congress will approve expanding oil storage capacity, and whether Texas oil producers will eventually reach a coordinated production cut agreement, will continue to cause significant fluctuations in oil prices this month.
APPENDIX 1 – WORLD OIL MARKETS INTRODUCTION?
Brent Crude Oil
Brent crude oil is a light, sweet crude oil produced in the North Sea Brent region. It reflects the oil supply and demand levels in Europe and Asia and is an international benchmark for oil prices.
West Texas Intermediate (WTI) Crude Oil
WTI crude oil is a light, sweet crude oil produced in the western United States. WTI oil prices primarily reflect the local supply and demand levels in the US, particularly influenced by inventory levels in the Cushing, Oklahoma region. Both Brent and WTI prices serve as important benchmarks for global oil prices.
APPENDIX 2 – SHALE OIL VS. CONVENTIONAL OIL
Shale oil is a type of oil, but it has significant differences in structure, storage, and extraction methods compared to conventional oil. These differences can be seen in the following aspects:
Chemical Composition
Shale oil is a product formed from the thermal decomposition of organic matter in oil shale. It is like natural petroleum but contains more unsaturated hydrocarbons and non-hydrocarbon organic compounds such as nitrogen, sulfur, and oxygen. In contrast, conventional crude oil does not contain olefins, has a lower nitrogen compound content, and even fewer oxygen compounds. Due to these differences, the quality of shale oil is currently lower than that of conventional crude oil.
Storage Method
Conventional crude oil is directly buried underground and exists in liquid form. Shale oil is mainly stored in shale formations, including oil in shale pore spaces and fractures, as well as oil resources in tight carbonate or clastic rocks adjacent to shale formations.
Extraction Method
The extraction process for conventional oil is relatively simple—drill wells in the areas with oil reserves, and crude oil can be extracted, particularly in the Middle East, where the oil is mostly light. It can be used immediately after extraction.
Compared to conventional oil, shale oil extraction methods are more complex. Currently, there are various methods for shale oil extraction, with horizontal drilling being the most popular technique. It involves drilling horizontal wells from vertical wellbores to increase the extraction density. After the completion of horizontal wells, high-pressure fluids are injected into the wells to break the shale layers, exposing the oil.
Apart from this technique, there is a relatively primitive method for shale oil extraction, which involves directly crushing oil shale and heating it to around 500°C to obtain shale oil mud. The shale oil mud is then processed using methods such as pressure filtration or centrifugal separation and drying. However, the oil content of the resulting mud and sludge does not meet national standards, and the disposal of the sludge and wastewater during discharge causes secondary pollution.
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