What to Make of the New Oil Deal

Whilst COVID-19 has dominated headlines this year, oil has also grabbed eyeballs. Brent crude oil prices plunged nearly -80% in Q1 2020, likely due in part to COVID-19—as well as a price war between Saudi Arabia and Russia.^[i] On Sunday, though, a détente emerged: The Organization of the Petroleum Exporting Countries (OPEC) and other big oil producers including Russia—a group known as OPEC+—agreed to a record-high oil output cut. Many financial commentators we follow doubt the production cuts will be effective at curbing a supply glut, and we largely agree with their take. We also doubt oil price changes will have much impact on global economic growth in the near term, for better or worse.

The 23 OPEC+ nations agreed to cut output by 9.7 million barrels per day (bpd), just shy of their 10 million bpd goal.^[ii] Saudi Arabia is leading the way, cutting production from its April output of 12.3 million bpd to about 8.5 million bpd.^[iii] Major nations not part of OPEC+—including the US, Brazil and Canada—are also reducing output, though market forces are driving those cuts. Mexico, which threatened to abandon talks last week, will cut 100,000 bpd of output, less than one-third of what OPEC+ wanted.^[iv] The US saved the deal by pledging reductions in Mexico’s stead. This won’t be a government-ordered production cut. Rather, officials factored in the US Energy Information Administration’s (EIA) projection for American oil output to fall about 500,000 bpd from 2019 as weaker prices prompt producers to cut back.^[v]

According to our analysis, the deal isn’t as expansive as it first appears. Saudi Arabia’s new production is just 1.2 million bpd lower than its average production before the price war began.^[vi] G-20 countries’ reductions are estimates based on current lower oil prices—should prices rise significantly, output may not fall, as the incentives will shift. The planned reductions also taper off over time. According to the agreement’s terms, the 9.7 million bpd cut lasts only through June. From July through yearend, the cut decreases to 7.6 million bpd—and then to 5.6 million bpd through 2021 until April 2022. Considering the deal doesn’t take effect until 1 May, we think it is fair to assume many producers will probably continue pumping at higher levels over the next several weeks—adding to the supply glut. OPEC members’ compliance with production targets has historically been spotty, too. Considering the struggle to get 23 parties on board with an agreement, and the large role oil production plays in some of their national economies, we suspect there is a chance some don’t follow through.

But even if all parties comply with the letter of the deal, we doubt it will address all of oil’s woes. Even a historic output cut doesn’t materially alter an ongoing supply glut. Around the world, oil storage is getting close to the brim, with many producers taking to storing oil on ships idling in the seas—a sign of dwindling on-shore storage capacity. Also, COVID-19 has destroyed demand. Estimates vary, but some believe the coordinated cuts will account for just half of the demand losses due to the coronavirus.^[vii] In its April Short-Term Energy Outlook, the EIA forecasts 2020 global oil consumption to fall about -5% from 2019.

The reasons demand is down are largely the same reasons we think oil prices are even less of an economic driver than normal now. Hardly anyone is flying or driving. Many factories in America and Europe remain idle. Oil swings affect transport costs for the essential goods everyone is stockpiling, as well as home heating costs. But we think that is likely the extent of their impact. When most shops are closed, changes in petrol prices can’t have much effect on non-essential household spending.

In our view, the global economy’s prospects today depend on how long COVID-19 restrictions remain in place. Should those draconian measures relax soon and allow life to regain some normalcy, the economic recovery may be quick—and likely won’t depend on whether oil prices are materially higher or lower.