Introduction
I am not an expert on oil by any means, although I have on many occasions been involved in the financing of independent oil & gas companies in the U.S., mostly high yield credits. I have also worked with some of the largest and most successful oil companies located in emerging markets including Brazil, Mexico, Russia and the GCC. In nearly all cases, the former are independent stand-alone companies, whilst the latter are either state-owned or heavily state influenced because the oil reserves of these countries are immense and represent a substantial portion of their wealth. The balance of supply and demand of oil in the world is of course delicate, with much of the world’s supply being controlled by the Organization of Petroleum Exporting Countries, or OPEC. OPEC is a cartel which started with five countries in 1960 and has 13 members today: Algeria, Angola, Congo, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Saudi Arabia, United Arab Emirates and Venezuela. OPEC+ refers to a group of 23 oil producing countries, including the 13 members of OPEC, with the additional “plus” members including Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russia, South Sudan and Sudan. According to a recent article in Bloomberg which you can find here, OPEC (26%) and the expanded OPEC+ controlled around 43% of the world’s daily production of around 100 million barrels/day prior to COVID-19. Perhaps equally important, OPEC is believed to be sitting on nearly 80% of the world’s proven oil reserves today.
Depending on one’s perspective, OPEC can be viewed as a multi-country organisation with the objective of stabilising prices to ensure the well-being of its members, or as an illegal cartel that has had, at least in the past, enormous leverage at times over countries – many western - that must import oil to meet their domestic needs. Over time, several OECD countries (i.e. the Organisation for Economic Co-operation and Development, consisting of 34 developed markets countries) have developed self-sufficiency as high global oil prices have acted as a catalyst that has made it economical to develop their own oil exploration, production and refining capacity. The largest oil consuming country in the world – the United States – became self-sufficient and therefore energy independent in 2018, thereby reducing the political leverage exercised by OPEC and OPEC+. Of course, there is a catch, which I will discuss later in this paper.
The economic disruption in the economy caused by COVID-19 has led to a decrease in the demand for oil by 30% or more. With this imbalance, oil prices began to plummet in February. With encouragement from the Trump Administration (more on this below), the dramatic decline in prices finally convinced OPEC+ to reduce their supply of oil. This has been woefully ineffective for reasons I will discuss below, and the current price of oil – shall it last very long - will have collateral effects on both the industry in general as well as many of its principal actors.
A Quick Look at WTI vs Brent Crude
“WTI” means West Texas Intermediate oil, produced mostly in the U.S. states of Texas, Louisiana and North Dakota. Brent North Sea Crude (“Brent Crude”) originates off-short in the North Sea between the Shetland Islands and the North Sea. Brent is used much more often as a barometer of oil prices than WTI, because it is more plentiful, has lower transportation costs (since WTI oil is essentially landlocked), and is purchased globally. As you might suspect, WTI is the most relevant pricing metric for the U.S., whilst most internationally transported oil, e.g. from OPEC, is priced using Brent. The U.S. oil market, which is nearly self-sustaining as you will learn further below, is increasingly an indigenous market because of the demand-supply balance, making WTI the most effective barometer in the States. Both classifications of oil are considered “light” and “sweet”, meaning that they are ideal for refining into gasoline. The prices normally move in tandem, but they can diverge especially during periods of political turmoil that threaten production from the Middle East. The graph below from FRED shows the prices of each since 1990.
Why Didn’t the Recent Supply Reductions Work?
The recent 9.7 million bbl/day reductions agreed by OPEC+ on April 12th and effective May 1st have not had the positive desired impact on oil prices. This should come as no surprise given that demand has decreased by significantly more (30 million bbl/day+) than the supply reduction. Global supply pre-COVID-19 was circa 100 million barrels/day, aligned with global demand. In 2019, the U.S., Saudi Arabia and Russia accounted for 42.5% of world’s supply, whilst the U.S. and China collectively accounted for 34.7% of the world’s demand, as the tables below illustrate (data largely from U.S. Energy Information Administration (“EIA”):
In a nutshell, the 9.7 million barrels/day reduction in supply is welcome, but the reality is that it hardly moves the dial when demand has decreased by 30 million barrels/day if not more. As the chart below illustrates, the effect on oil prices has been nil since it was announced (aside from the several day build-up to the formal announcement), as WTI prices have continued to plummet.
The dramatic fall in prices will have many collateral effects on the global economy and the world order, and I do not suspect prices to fully recover until we see either further dramatic reductions in supply, a recovery in the global economy (by the COVID-19 pandemic subsiding), or a combination of the two. I do believe that low prices will persist for several months, and when we’ll see the price above $50/barrel again is anyone’s guess.
What About the Other Side of the Equation - The Cost of Producing a Barrel of Oil?
The market price/barrel of oil has to be put in the context of the cost of extracting the oil, known in the industry as “lifting costs”.
In Russia, the lifting cost /barrel in 2019 for state-controlled but listed Rosneft, which produced 4.7 million barrels/day of oil last year, averaged $3.21/bbl based on the exchange rate at the end of the year (RUB 62.05 / USD 1.00), the second lowest in the world. However, the lifting cost/barrel of oil for Rosneft depends on the exchange rate between the Ruble and the US Dollar, since the company’s cost base is principally in Rubles and its revenues are principally in USDs. This means that as the USD has strengthened during this year, accelerating during the COVID-19 crisis, the cost/barrel of extraction for Rosneft has decreased significantly. Based on the current exchange rate of RUB 74.51/ USD 1.00, the average lifting cost per barrel has plummeted to $2.67/bbl, which is now the lowest in the world.
In Saudi Arabia, the lifting cost/barrel in 2019 for state-controlled (but listed) Saudi Aramco, which produced 9.9 million barrels/day of oil last year, was $2.80/bbl, as reported in the company’s 2019 annual report. At the time, this was the lowest in the world. Unlike Russia, which has a free-floating currency, the Saudi Arabia Riyal is pegged to the USD at SAR 3.75 / USD 1.00, so strength or weakness in the US Dollar over time does not affect the company’s cost base.
As far as the U.S., I have read that the lifting cost/barrel of oil ranges from the mid/high $20/barrel to around $35/barrel or more for independent oil & gas companies engaged in fracking. A Reuters article in March said that Exxon Mobile’s lifting cost was $26.90/barrel in its New Mexico fields (i.e. the Permian basin), which I presume is its lowest cost field. The article goes on to say that only 15 U.S. fracking companies have lifting costs below $35/barrel, with the industry average being $43.83/barrel (source: oilprice.com).
Before leaving the cost discussion entirely, Rosneft (and other Russian producers with Rosneft, collectively) and Saudi Aramco both produce more oil than their respective countries consume, so they export a significant portion of their production. Of course, transporting and storing oil costs money. Both Saudi Aramco and Rosneft have a different mix of oil and natural gas extraction, and both also provide downstream products, meaning that they are involved in refining, retails sales, etc. Although admittedly far from perfect and in some respects comparing “apples to oranges” (because every major petroleum company has different attributes and a different business mix), the ratio of i) cost base before taxes and interest to ii) barrels of hydrocarbons produced for 2019 results in an “all-in” cost/barrel for Saudi Aramco of around $31/barrel and for Rosneft around $49/barrel. The western major oil companies appear to be at $100/barrel or more all-in. Relatively speaking, these comparisons deserve consideration, although the absolute results are certainly not entirely accurate, especially for the more diversified western major oil companies that are much more heavily involved in downstream products.
Two final things to keep in mind before closing this section are i) unlike Russia, Saudi Arabia and many of the other large oil-producing countries, the U.S. exports very little oil due to the country’s consumption (resulting in an almost indigenous market for oil), and ii) the U.S. oil & gas industry is entirely in the hands of the private sector.
Why Did WTI Prices become Negative?
Those folks involved in the futures markets can certainly provide a more detailed answer to this than I will be able to, but I will give it a crack. The supply-demand imbalance drove the price of oil down considerably, but it still shouldn’t make it negative. However, a nuance of oil futures, used heavily by suppliers and companies alike to hedge, is that the contracts require physical – not financial – settlement. That means that upon expiry, the physical oil is actually sold or bought (rather than there simply being a financial “true up”). Last Tuesday (April 21) was the day that WTI futures contracts for May delivery of oil were to expire. However, potential purchasers / end users, e.g. refineries, petrol stations, airlines, trucking companies, etc., had little interest because of the dramatic reduction in demand. However, the sellers of the futures contracts had oil to deliver in May under contract closing that day. Since there is a cost to store or carry oil, the suppliers had to subsidise the ever-increasing storage cost for buyers in the run-up to the expiry of the futures contract to induce them to take oil they did not want or need in May, effectively resulting in a negative net price for oil the day before the contract was set to expire. In other words, sellers had to effectively pay buyers to take oil for May delivery. Below is a graph showing just how bizarre this one-off price looked in a historical context.
The price of WTI quickly bounced back to positive territory after the May WTI futures contract expired, and the forward curve for futures contracts for delivery in June and beyond is upward sloping (known as contango in the commodities market). Also, it is worth noting that this rather bizarre but short period of negative prices was only for WTI, not Brent Crude. The production side will gradually adjust to the new price levels which should prevent the negative price of WTI from happening again.
U.S. Energy Independence / Self-Sufficiency
Since the embargo imposed by OPEC countries on oil shipments to the United States in 1973 as a response to U.S. support for Israel during the Yom Kippur War, the U.S. has sought energy independence. Ultimately, it achieved such independence but only after many years and only then after the use of horizontal fracking became widespread. The U.S. became the largest oil producer in the world in 2013, passing Saudi Arabia. As the graph below illustrates, the country has largely met its objective to become energy independent by doubling its production since 2010, thanks to the aggressive use of fracking, whilst consumption has remained relatively flat.
The consumption trend in the U.S. has largely levelled off even as the economy has continued to grow, due mainly to lower usage in transportation (e.g. ethanol substituting for petroleum, better fuel efficiency and higher gasoline prices which encourage less driving) and the slow evolution of alternative sources of energy.
It is clear that the United States objective of achieving and maintaining energy independence will be threatened if prices of oil remain at the current low levels, or realistically, at any level that is below $50/barrel or in that neighbourhood. The U.S. oil & gas market is a “free market” in that activity (meaning exploration and drilling) subsides when prices fall and increases when prices rise. It has often been characterised as a “boom & bust” industry, which is certainly at least partially true. Nonetheless, at these price levels there will inevitably be concern within the U.S. government about seeing higher cost domestic production decline considerably, thereby returning the U.S. to a reliance on oil from the Middle East, viewed as unstable, or from Russia, viewed as untrustworthy. As a result, this fear might very well cause the U.S. government to take some steps to provide support for domestic oil & gas companies, which otherwise will reduce production or even go bankrupt at this cost/barrel. Some sort of assistance has been rumoured now for a couple of weeks, although so far, there has been no specific stimulus measure focused on this sector. Should such support ultimately crystallise, it could be in several forms. For example, the government could simply pay companies to keep their oil in the ground, or the government could lend them money or buy equity stakes to fund (scaled-down) operating expenses during this period of economic closure.
What about storage and tankers?
Global oil storage capacity is estimated to be around 6.8 billion barrels, with 60% or slightly more of this currently filled (from New York Times). Storage can occur under ground (in salt caverns), in open-top on-shore tanks generally located near ports or refineries, or in tankers at sea, normally used to transport – not store – oil. Most storage is on-shore, although tankers have had some of their capacity morph into what are effectively storage facilities because the oil they contain currently has no buyer (and hence, no destination). The estimated global tanker capacity is 2.4 billion barrels, of which upwards of around 200 million barrels is being used for storage. Clearly, as the storage capacity becomes increasingly stretched, the profitability of storage facilities, especially tankers, improves rapidly.
According to Rystad Energy, total onshore commercial storage, including oil in transit and in pipelines, is estimated to be 780 million barrels, of which perhaps 20% is still available. The Strategic Petroleum Reserve (“SPR”) for the U.S. holds 713.5 million barrels and has perhaps 10% capacity. At these rates, Rystad Energy is anticipating that the U.S. storage, both commercial and the SPR, could be full by June. Other sources are saying it could occur even sooner.
Effect on Oil Producing Emerging Markets Countries
The current price of oil has implications well beyond the U.S. For OECD countries which import most of their oil, it could be argued that they are de facto receiving a good dose of fiscal stimulus because their energy costs are declining significantly. However, for exporting countries, the cost of the dramatic decline in the price of oil can be very severe. The dichotomy between the better-off emerging markets countries and the poorer emerging markets countries is dramatic.
Oil as a percent of the total economy, measured by GDP, accounts for 60% of GDP for Kuwait, 50% for Saudi Arabia, and 30% for both Russia and UAE. Oil represents only 8% of the economy of the U.S. Naturally, these producing countries, most of which have nationalised oil companies, will feel the effect of much lower prices on their budgets, which I will discuss in a moment. Moreover, there are direct trickle-down effects such as lower tax revenues and employment / cost reductions, generally not entirely offset by lower fuel prices since many of these countries already sell oil and natural gas below cost as a benefit / subsidy to their population. Let’s return though to the effect on the fiscal budgets of oil exporting countries.
For oil exporting countries, the price of oil that results in a balanced budget depends on the overall size of the budget and the relevancy of oil revenues in the budget. Below are break-even prices per barrel for oil for a few countries, obtained from a Forbes article dated April 21st that you can find here.
Middle East: Saudi Arabia, $91/barrel; Oman, $82/barrel, Abu Dhabi, $65/barrel; Qatar, $55/barrel; Bahrain, $96/barrel; Iraq, $60/barrel; and Iran $195/barrel (source: Fitch Ratings).
Africa: Algeria, $109/barrel; Libya, $100/barrel; Nigeria, $144/barrel; Angola, $55/barrel (source: IMF).
Non-OPEC countries: Russia, $42/barrel; Mexico, $49/barrel; and Kazakhstan, $58/barrel.
Many of the countries mentioned in the Middle East (the GCC countries) and the non-OPEC countries can tolerate fiscal deficits for two reasons. Firstly, many have set aside substantial amounts of past petrodollar revenues in sovereign wealth funds, to be used for “rainy days”, meaning periods when prices are exceptionally low. Secondly, some of these countries, particularly the GCC countries, have ready access to the international capital markets to raise financing to plug budgetary gaps. For example, Qatar, Saudi Arabia and Abu Dhabi collectively raised $24 billion in multi-tranche bond issues in the last three weeks, at attractive coupons and with maturities out to 40 years. These strong exporting countries will feel the pain of low oil prices but will be able to carry on without significant cuts in their social programmes because of a combination of debt financing and savings.
The story is sadly very different for the poorer oil exporting countries, which have limited or no access to external funding and have not set aside money for a “rainy day” in sovereign wealth funds. Probably the worst off is Venezuela, with the situation made worse there because of the current political backdrop. The national oil company PDVSA is arguably technically bankrupt, and the country’s population is very poor. The other most concerning cases are in Africa, with Nigeria leading the pack. These countries will have no choice but to dramatically cut their expenditures, meaning social programmes like schooling, healthcare, unemployment benefits, and so on, in order to make ends meet during this downturn. Fortunately, there should be some assistance coming from the G20, which has agreed to waive debt service payments through the end of 2020, and from the IMF, which is standing by willing to offer assistance to the most beleaguered countries.
The Effect on Alternative Energy
The fear for alternative energy, meaning clean energy and renewables, is that the cost of these alternatives become increasingly expensive compared to petroleum-based products, like gasoline to power cars and trucks, and natural gas used for hot water and cooking. High oil prices provide short-term benefits for oil producers, but also make the economic case for alternative energy sources compelling. Today, one might argue that the shoe is very much on the other foot. The Financial Times covered this in an article on March 10th that you can find here.
The story does not end here fortunately, as the combination of regulatory and investor pressure will likely result in this significant downturn in the price of oil being only a speedbump in the growth of alternative energy sources. This downturn should not cause people to lose their will to achieve lower global carbon emissions and rescue the environment for future generations. The combination of regulatory pressures and government subsidies will continue to favour the development of alternative energy, not only as a saviour for the environment but also to reduce the world’s dependency on fossil fuels, especially for countries that import oil. Shareholders, especially institutional investors, are applying pressure on companies to make sure that they commit to reductions in carbon emissions and invest accordingly. More and more asset managers are shying away from fossil fuel companies - including not only oil companies but also companies that use gasoline, jet fuel, etc. - to demonstrate that they are serious about the environment and to ensure that these companies collectively work towards reductions in carbon emissions.
Conclusion
Oil, or “Texas Tea”, really does have a life of its own and a very interesting history. This unprecedented period of unusually low prices will likely pass once we can see the light at the end of the COVID-19 tunnel. Only then will we be able to evaluate the lasting effects of this highly unusual period of ultra-low prices on global oil production and consumption, as well as on major oil importing and exporting countries.