Saudi Arabia made headlines earlier this week after announcing a surprise oil production cut—right after OPEC+ (OPEC plus 10 partner countries including Russia) agreed to keep output flat. As oil prices rallied, analysts debated whether a shift was underway in global oil markets. However, we think the drivers for oil prices remain little changed: Supply remains plentiful given weak demand tied to COVID restrictions. In our view, this balance doesn’t look likely to change materially for the foreseeable future—important to keep in mind for those seeking opportunities in the Energy sector.
To understand why, start by considering what OPEC and friends have been up to over the past year. At 2020’s start, OPEC+ produced about 42 million barrels of oil per day (bpd).[i] After a price war between Saudi Arabia and Russia erupted in March, OPEC+ reached a US-brokered détente in April. Per the agreement, the group would decrease output by 9.7 million bpd—approximately 13% of global production—in May and June, then gradually taper those cuts. After June, the 9.7 million barrel cut would drop to 7.7 million through the rest of 2020—and then fall to 5.8 million through 2021 until April 2022, when the deal ended.[ii] In other words, they would cut a lot at first, then gradually ramp up production a tad—but nowhere close to the starting point.
However, not all has gone according to plan, and the group has struggled to hit their original targets. Though OPEC+ allowed 2 million bpd to return to the market in August, they have refrained from further easing, citing concerns of a still-fragile oil market. As of January 2021, OPEC+ output is still 7.2 million bpd below year-ago levels—nearly 2 million bpd more than the agreement’s initial aim.[iii]
Against this backdrop, Saudi Arabia surprised many with its announcement this week of a 1 million bpd production cut in February and March. Most other OPEC+ members plan to keep production steady in the coming months, so some observers saw the Saudis’ decision as a statement about the kingdom’s influence over the global oil industry. Our focus isn’t on the oil sector’s political dynamics—we care only about potential economic and market impact. In our view, Saudi Arabia’s big voluntary cut suggests the kingdom apparently isn’t interested in a price war with Russia, although considering we haven’t bugged anyone’s office, that is an educated guess. Moscow has pushed for increasing production to take advantage of higher oil prices and to maintain its market share. The Saudis seemed to make a small concession, as Russia (as well as Kazakhstan) was permitted a minor production increase the next two months. So it isn’t clear that this move means a big global supply reduction is in the offing. But it does indicate OPEC+ is mindful of weak demand due to COVID-19’s economic fallout—a headwind investors should keep in mind.
Though headlines focus on OPEC+ drama, supply and demand drive oil prices. In the case of the former, global supply remains plentiful. There is a big reason why many OPEC+ members are loath to make cuts: Most depend heavily on oil revenues to finance government spending, so deep and lasting production cuts wouldn’t be tenable economically or politically. Consider: In the extreme case of Venezuela, oil revenues account for 99% of export earnings.[iv] Saudi Arabia also relies on oil to fund its citizens’ welfare benefits—critical for social stability. Meanwhile, outside OPEC and its partners, production has surged, including in the US’s shale patch. Yes, falling oil prices whacked producers there in recent years, and COVID fallout exacerbated the pain—causing many smaller producers to go bankrupt. However, surviving firms have tightened their belts and appear more focused on fiscal discipline and reducing debt—a contrast to the recent past, when the shale industry’s primary focus was grabbing market share. But belt-tightening means making productivity gains and drilling judiciously—it doesn’t necessarily mean chopping output, which most US producers expect to remain flat for the foreseeable future. The technology also enables producers to ramp up relatively swiftly if prices start climbing and make it worth their while.
On the demand side, COVID-driven lockdowns and restrictions have wrecked consumption, particularly in Western developed nations. For example, the US didn’t import any Saudi crude for the first time in 35 years last week—an aberration, perhaps, but one reflecting reduced domestic demand.[v] Looking more broadly, 2020 global oil demand was 91.2 million bpd—8.8 million bpd below 2019’s level—according to the International Energy Agency’s (IEA) latest estimate.[vi] Global demand recovered in the second half of the year thanks primarily to China—unsurprising given its relatively quick reopening post-COVID lockdown.
Looking forward, the IEA projects 2021 global oil consumption will average 96.6 million bpd—an increase of 5.7 million bpd on 2020’s levels, though still below 2019’s.[vii] While the research outfit estimates a near-full recovery in gasoline and diesel demand, jet fuel/kerosene consumption may take longer to regain its pre-pandemic levels. Other organizations, including OPEC, have similar 2021 projections. These forecasts aren’t destiny, but they reveal expectations and make a simple point: COVID restrictions have roiled demand, from long-haul air travel to work commutes, against a backdrop of an already oversupplied market.
We have long argued an economic recovery depends primarily on the easing/ending of COVID restrictions and a return to normalcy. This is likely no different for oil—especially on the demand side. Against this backdrop, Energy firms still face tough sledding. In our view, some exposure makes sense for diversification, but focus more on large, globally positioned firms with strong balance sheets, able to weather this environment better than smaller firms.
H/T: Fisher Investments Research Analyst Scott O’Leary
[i] “OPEC+ Agreement to Reduce Production Contributes to Global Oil Market Rebalancing,” Eric Han and Candace Dunn, EIA, 9/23/2020.
[ii] “The 10th (Extraordinary) OPEC and non-OPEC Ministerial Meeting Concludes,” OPEC, 4/12/2020.
[iii] “OPEC Production Rose Last Month as Libya Continued Comeback,” Grant Smith and Julian Lee, Bloomberg, 1/6/2021.
[iv] “Venezuela Facts and Figures,” Organization of the Petroleum Exporting Countries. Date accessed: 1/7/2021.
[v] Source: “U.S. Imports No Saudi Crude for First Time in 35 Years,” Sheela Tobben and Julian Lee, Bloomberg, 1/6/2021.
[vi] Source: “Oil Market Report – December 2020,” International Energy Agency. Date accessed: 1/7/2021.
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