The U.S.-China trade war has ignited fears of an economic slowdown, dragging down oil to multi-month lows. Oil demand is under scrutiny, not least because China is the largest importer of crude in the world.
However, the recent slide in oil prices and the sudden bout of bearishness surrounding the trajectory of the oil market also significantly increases the odds that OPEC+ will not abandon the production cuts when the group meets in Vienna in a few weeks’ time. Instead, the cuts will likely be extended in order to head off another steep downturn.
Pressure on OPEC+ to act eases
In recent weeks, the pressure on OPEC+ to back off production cuts had been mounting. The production curtailments of 1.2 million barrels per day (Mbd) since the start of the year helped to tighten up supply/demand balances. In addition, the severe outages in Venezuela and the more recent plunge in oil exports from Iran threatened to push the market into a substantial deficit. Fighting in Libya also poses yet another potential outage. With OECD inventories at roughly even with the five-year average in March and moving down, oil was staring at an overly tight market in the second half of the year.
The members of the OPEC+ coalition have different economic incentives. Most member countries are producing as much as they can and have little scope for higher output, so they are on board with an extension of the cuts. Saudi Arabia and its Gulf allies want to keep up market management in order to keep prices elevated. Russia, on the other hand, is not as aggressive in its pursuit of higher prices. For one, some producers in Russia are private companies, and they are reluctant to cut output. Also, because the Russian ruble floats freely it does not feel as much pressure from modest or even low oil prices as does Saudi Arabia. In addition, top Russian officials are concerned that higher prices play into the hands of U.S. shale drillers, something that is viewed as a strategic threat in some corners of Moscow.
As such, only a few weeks ago, Russia seemed eager to increase production. In March, Russian energy minister Alexander Novak reportedly told his Saudi counterpart that he could not guarantee Russia’s support for an extension of the production cuts. A source told Reuters that Novak was “under too much pressure internally to end the cuts.” At an Arctic Conference in St. Petersburg in April, President Vladimir Putin said it was too early to say whether or not the cuts should be extended, but he added that “we are not supporters of uncontrollable price rises.” With Brent above $70 per barrel and more outages on the way from Iran and Venezuela, the pressure to back off production cuts was mounting.
However, the U.S.-China trade war has deflated the market, raising fears of an economic slowdown. Coinciding with higher tariffs has been a string of weak economic data. China has reported a dramatic decline in car sales. But the problems in the auto industry are global, and Fitch Ratings estimates that weaker sales last year dragged down global GDP by 0.2 percent. Weak data has also cropped up for services, manufacturing and other sectors. Morgan Stanley says the U.S. economy is on “recession watch.”
Stockpiles data has not been promising either. In recent weeks, crude oil inventories surged by much more than expected, rising to nearly two-year highs. In the most recent week, stocks fell by a marginal 0.3 million barrels, a weaker draw than expected. When EIA released the data on May 30, crude oil prices plunged on the news.
Meanwhile, the International Energy Agency has revised down its assessment for first quarter demand, perhaps the most significant data point yet that points to a slowdown. In mid-May the agency said that demand grew by 640,000 barrels per day (b/d) in the first quarter, much lower than its prior estimate of 1 Mb/d.
OPEC to stick with cuts
As if to reinforce the wisdom of keeping the cuts in place, the U.S. seems to be softening its stance on countries importing oil from Iran. The Trump administration had let waivers expire, but for now is allowing countries to import some volumes of oil so long as they do not hit the caps negotiated under the prior waivers, according to the Wall Street Journal. In late April, when the U.S. took a hardline on Iran, all eyes turned to Saudi Arabia to see if Riyadh would increase production to offset outages. Now, Saudi officials are likely pleased that they did not rush to pump more oil into a softening market.
The big question, then, is how U.S. shale will respond. U.S. production actually declined in the first few months of 2019, dipping to 11.7 Mbd in February, down from 11.9 Mbd in December. But the decline was largely due to some maintenance offshore. The weekly estimates from the EIA have output much higher at 12.3 Mbd as of late May, although that data is subject to revision. The EIA maintains that the U.S. will add huge volumes of new supply, with production averaging 13.4 Mbd next year.
But U.S. shale’s growth can no longer be taken for granted. The industry is facing financial stress, with 9 out of 10 companies posting negative cash flow in the first quarter, according to Rystad Energy. Pressure from shareholders are forcing companies to focus more on capital discipline, which could translate into a more conservative approach. “A slowdown in drilling, lower capital allocations and faster base declines underpin our weaker growth projections for the US,” the IEA said in its May Oil Market Report. The agency predicted that the 0.7 Mbd surplus seen in the first quarter of 2019 will flip into a similar sized deficit in the second, but the economic clouds have darkened since that prediction was made.
OPEC+ delegates will be heading to Vienna with less of a conundrum than seemed to be the case just a few weeks ago. Unless there is an unexpected outage – in Libya, for instance – the recent cracks in demand and the prospect of an economic downturn makes the choice to extend the cuts an easy one.