While COVID-19 has dominated headlines this year, oil has also grabbed eyeballs. Brent crude prices plunged nearly -80% in Q1 2020 thanks partly to COVID-19—but also to 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 producers including Russia—a group known as OPEC+—agreed to a record-high oil output cut. The US even helped broker the deal, which nearly collapsed after Mexico pulled out of talks last Friday. However, doubts remain about the production cuts’ effectiveness—understandable given the factors affecting oil supply and demand today. In our view, this also highlights a broader point for investors: Despite receiving lots of attention, oil price changes won’t have much impact on the present macroeconomic situation, for better or worse.
The 23 OPEC+ nations agreed to cut output by 9.7 million barrels per day (bpd), just shy of its 10 million bpd goal. Saudi Arabia is leading the way, cutting production from its April output of 12.3 million bpd to about 8.5 million bpd. G-20 countries not part of OPEC+—including the US, Brazil and Canada—are also reducing output, though market forces are driving those cuts. Mexico, which nearly torpedoed the agreement, will cut 100,000 bpd of output, less than one-third of what OPEC+ wanted. The US saved the deal by pledging reductions in Mexico’s stead. Not that America is turning into a command-and-control economy, mind you—last week, the EIA projected domestic oil output would fall about 500,000 bpd from 2019 due to weaker prices. Price signals, not politicians and regulators, primarily govern US output.
Yet 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. G-20 countries’ reductions are estimates based on current lower oil prices—should prices rise significantly, output may not fall. The planned reductions also taper off over time. 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 May 1, many producers will probably continue pumping at higher levels over the next several weeks—adding to supply. OPEC members’ compliance with production targets has historically been an issue, too. Oil supports many of their economies, and despite public pledges of solidarity, not all participants stay within their quotas. Considering the struggle to get 23 parties on board with an agreement, it seems fair to say there is a chance some don’t follow through.
But even if all parties comply with the letter of the deal, oil’s troubles aren’t fixed. Even a historic output cut doesn’t materially alter an ongoing supply glut. Around the world, oil storage is getting close to the brim. Producers have even taken to storing oil on ships idling off coasts around the world—a sign of dwindling 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. 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 oil prices are even less of an economic driver than normal now. Hardly anyone is flying or driving. Many factories are idle. Oil swings affect transport costs for the essential goods everyone is stockpiling, as well as home heating costs. But that is about it. Lower costs won’t provide a boon to discretionary spending, and higher fuel costs won’t curtail it.
The main area of impact will be on the oil industry itself, and those winds were already moving. In the US, falling oil prices have hurt shale oil producers, many of which have a higher break-even price—the level at which drilling is profitable—than Saudi Arabia and Russia. Given ongoing low prices and a history of pursuing growth at all costs, many smaller producers are struggling to meet their obligations—which may lead to some firms going bankrupt and a wave of consolidation in the industry. It isn’t clear whether output cuts can change this in the immediate future. But the oil and gas industry has been struggling from a profit perspective amid middling oil prices for years. Hence, it has already fallen to such a small share of total US economic output—about 1% of GDP in 2019—that even continued problems probably won’t move the needle. Some claim mass layoffs in the oil patch eliminate high-paying jobs needed to fuel an economic recovery, but this is really just putting an industry-specific spin on the timeless recession worry that you need jobs to get growth. History shows the reverse is true—growth begets jobs.
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 won’t depend on whether oil prices are materially higher or lower.
[i] Source: FactSet, as of 4/13/2020. Brent crude price percentage change, 12/31/2019 – 3/31/2020.
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