SINGAPORE (March 13): Crude oil prices have already taken a blow since the start of 2020. The out­break of the novel coronavirus or Cov­id-19 did not only infect more than 119,000 and kill more than 4,000, but also impeded economic activity. This led to ex­pectations of lower oil demand going forward.

Then came the second blow last weekend. Russia — one of the world’s largest oil produc­ing countries — snubbed Saudi Arabia’s pro­posal to collectively cut oil production in view of weak demand. Both countries were in Vien­na, participating in a meeting that comprised members of the Organization of the Petrole­um Exporting Countries (Opec) and certain non-Opec countries — which are collectively known as Opec+.

Following the collapse in talks, Saudi made an unexpected announcement. The Kingdom slashed its official selling price (OSP) by US$7– 8 per barrel ($9.74–$11.13 per barrel) to Eu­rope and the US and US$4–6 barrels to Asia. It is also reportedly planning to increase exports by up to 800,000 barrels a day (bpd) into an already over-supplied market.

As a result, crude oil prices saw their big­gest plunge since the 1991 Gulf War. The West Texas Intermediate (WTI), the US benchmark, and Brent crude, the international benchmark, plummeted as much as 30% when financial markets opened on March 9. Both crudes have since marginally rebounded to US$31.33 and US$34.01 a barrel on March 12, bringing their year-to-date declines to about 48% each.

Singapore’s oil plays, unsurprisingly, suf­fered sharp selldowns. Keppel Corp, for ex­ample, closed at $5.15 on March 12, down 17.2% from previous Friday’s close; Sembcorp Marine was down 19.3% over the same peri­od. Smaller players in the support and servic­es, such as Rex International Holding, AusGroup and Interra Resources were actively sold down by 28.3%, 30.6% and 27.4%, respectively, as well.

“This is not the first time we’ve seen a price war — the last was as recently as 2015 [and] 2016. But this time, oil demand is also weak as the [Covid-19] outbreak depresses global eco­nomic growth,” Tom Ellacott, senior vice pres­ident, corporate upstream, Wood Mackenzie, said in a March 9 statement.

“The shock-and-awe Saudi strategy will propel oil markets into a period of radical un­certainty. Russia baulking was one thing, but Saudi ramping up production is a bird of an­other feather,” says Stephen Innes, chief mar­ket strategist at AxiCorp.

“Basically Opec has failed to do what it al­ways does and that has created a rout in the oil market,” says Bhaskar Laxminarayan, Ju­lius Baer’s CIO and head investment manage­ment in Asia.

To add to an already volatile mix, two mem­bers of the Saudi royal family were arrested over the weekend. Their arrests were seen as a move to smoothen the transition of power to Saudi Crown Prince Mohammed bin Salman in the future. This, however, will hardly help to stabi­lise short-term investor sentiment about politi­cal stability in the Kingdom and its connection to the oil price, says UBS Asset Management.

Will crude oil prices trade lower ahead? Or will Saudi and Russia kiss and make up and drive crude oil prices up? “The honest answer is that nobody really knows yet how this will all play out, we just don’t have that data avail­able to us, no matter how learned. The best answer, I believe, is to plan for the worst and hope for the best,” says Jeffrey Halley, senior market analyst, Asia Pacific, Oanda.

Saudi vs Russia

According to DBS Group Research, Russia’s walking away from further steep production cuts serves key political purposes that are hard to miss. The brokerage says the move signals “strongman tactics” ahead of its impending na­tional referendum on constitution amendments. On the other hand, Saudi’s deep discounts of its oil is aimed at taking market share from Rus­sia, unless there is consensus on production cuts, it adds. Meantime, this will squeeze the US shale oil industry, which has gained mar­ket share at the expense of Opec.

Based on DBS’s estimates, Saudi alone has the potential to increase supply by more than 2 million bpd from current levels. Iraq and UAE could raise supply by around 400,000 bpd each, and Kuwait by another 200,000 bpd. That makes a total of 3 million bpd spare capacity from just four countries, ignoring other small­er member states.

While this spare capacity cannot be pumped overnight, Opec can easily add 1.5–1.8 mil­lion bpd in 2Q2020 and 2.2–2.5 million bpd in 2H2020, says DBS. This is assuming that the oil cartel does not adhere to production discipline, and supplies from Iran, Venezuela and Libya are excluded, it explains. Among non-Opec countries, Russia can potentially increase pro­duction by around 400,000–500,000 bpd over the course of the year if it gets into the market share game, says DBS.

So, how long can Saudi and its Opec allies retain this aggressive posturing? It is hard to estimate, especially after the free fall in crude oil prices, according to DBS. “But, suffice to say, Russia can take the pain of lower oil pric­es longer than most Opec members,” DBS an­alysts Suvro Sarkar, Ho Pei Hwa and Paul Yong wrote in a note dated March 10.

According to Société Générale (SocGen), Russia relies on oil revenues for 37% of its budget and can run a fiscal surplus of 0.8% of GDP with Ural oil prices at US$57 a barrel, says SocGen. For Saudi, however, oil makes up 65% of the nation’s budget, and a US$50 bil­lion budget deficit is assumed this year with oil at US$65 a barrel, it adds.

DBS is more drastic. It says OPEC’s leading producers have a stronger need for “significant­ly” higher crude oil prices if they are to bal­ance their fiscal budgets. For example, Kuwait needs crude at US$55 a barrel, and Saudi, at US$84 a barrel. Russia on the other hand, with its more diversified economy, can get by with US$40 to US$45 a barrel.

At Saudi’s discounted prices, the Kingdom could lose an estimated US$120 billion, accord­ing to Schroders. In fact, current crude oil pric­es are significantly below the fiscal breakeven levels for all of the Opec producers, it adds.

“It is difficult to envisage that these prices can be sustained without significant cuts to fis­cal programmes, which in turn would lead to significant unrest,” says Mark Lacey head of commodities at Schroders. “In addition, cur­rent crude prices are below the operating cost of the industry for the whole of non-Opec as the largest integrated oil companies need to achieve at least US$35 a barrel to sustain cash operating costs.”

Meanwhile, US shale oil will suffer the brunt too. DBS notes that US shale production growth will come off sharply if WTI remains in the US$30 to US$35 a barrel range. This is be­cause the majority of US oil producers — es­pecially the highly-geared shale producers — can only drill new wells profitably when WTI is at least US$40 a barrel and Brent crude price is above US$45 a barrel.

Lower for how long?

If things do not improve between Saudi and Russia, crude oil prices will likely remain low in the near term. Based on SocGen’s base-case price, curve and volatility models, Brent crude could trade at an average price of US$30 a bar­rel in 2Q2020. It warns that Brent crude price could go lower to mid-US$20 a barrel. But then, it could inch up to an average of US$35 a barrel in 3Q2020. By 4Q2020, average Brent crude price could inch up further to an aver­age of US$40 a barrel. “In each quarter, we forecast deep contango,” say SocGen head of commodities research Michael Haigh and cross commodity strategist Florent Pelé.

DBS is more or less bearish. “We think a relatively quick bounce towards the US$40 a barrel mark is in the offing, as seen in the re­cent past when oil price tested the US$30 a bar­rel mark. The most recent case was in January 2016, when oil price recovered to more healthy levels within weeks. Of course, we also rule out a strong V-shaped recovery back to US$50 a barrel levels, as demand conditions current­ly are probably the worst since the post-GFC period in 2009,” it says.

Schroders, however, offers an alternative view. “The longer we stay at current oil pric­es, the more supply will be removed from the industry. This sets the market up for a peri­od of significant tightening and much higher prices, when we finally enter a period of sta­ble demand and restocking. For this stability, we need Covid-19 to dissipate, industrial activ­ity to restart and industries to destock. In the very short term, it is hard to see this happen­ing, but if we look beyond the short term, the upside risk to oil prices is significant,” it says.

For now, Saudi’s energy minister appears adamant not to proceed with the next Opec+ since there was no agreement to address the weak oil demand in light of Covid-19. “I fail to see the wisdom in holding meetings in May- June that would only demonstrate our failure in attending to what we should have done in a crisis like this and taking the necessary meas­ures,” Reuters quoted Prince Abdulaziz bin Salman as saying on March 10.