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Oil Production Cuts May not Prop up Prices

May 14, 2020
  • Wu Zhenglong

    Senior Research Fellow, China Foundation for International Studies

OPEC, Russia and several major oil-producing countries struck a historic agreement, after four days of intensive negotiations, to slash 9.7 million barrels a day in May and June. After that, they will cut 7.7 million barrels per day from July through the end of the year and implement a 5.8-million-barrel cut for 16 months beginning in 2021.

This extraordinary meeting, held at an extraordinary time, will have a critical impact on the future trajectory of the international market for crude oil.

To put things in context, the supply and demand sides of the global crude oil market are suffering simultaneously, creating a mismatch. This is something never seen before. One one hand, Saudi Arabia and Russia were locked in a price war, significantly increasing their production, resulting in an oversupply and plummeting prices. On the other hand, to prevent the spread of the coronavirus, many countries have imposed stay-at-home orders and lockdowns, which brought a cancellation of flights, reduced road traffic and closed factories.

Oil prices then plunged and the supply glut worsened. At one point, oil fell as low as $3 a barrel. The meeting aimed to reduce production and ultimately lift prices. But there are many signs that production cuts don’t necessarily buoy oil prices. 

The suggested production cuts are significant in terms of scale and time span. After all, the cuts in May and June alone amount to one-tenth of the current global supply. When their previous negotiations came to grief one month ago, Saudi Arabia and Russia launched a price war, cutting 3.2 million barrels per day altogether. But some analysts believe that to reverse the current mismatch between supply and demand, a 9.7-million-barrel cut per day is far from enough and that the figure should be at least doubled before it will be possible to deal with a collapse in demand.

The reductions will put an end to the price war and mitigate the negative impact on the oil supply. But on the demand side, problems remain unresolved, and they are the key factor behind oversupply.

The COVID-19 pandemic is the most significant cause of the plunge in demand; it is therefore imperative to contain its spread. Now the top priority is to flatten the curve as soon as possible and relax some of the anti-pandemic restrictions to lift demand for oil. Market demand will not grow until this task is fulfilled. Also, there are many uncertainties surrounding the pandemic. For example, where is the point of inflection? Will the virus break out again this autumn? When will the pandemic come to an end?

There is a considerable probability that the novel coronavirus will continue to exist in human lives for a long time; consequently, it is difficult to buoy oil demand before the advent of vaccines. While the race to develop a vaccine is well underway, some experts have said it will take at least a year to become available. In short, it is virtually impossible to increase oil demand before a vaccine hits the market.

The pandemic situation in Europe has begun to improve; the United States may not be far behind. But it will require long-term efforts to restart production because supply chains have been severely disrupted.

“The bleak outlook applies to advanced and developing economies alike,” IMF Managing Director Kristalina Georgieva said. “This crisis knows no boundaries. Everybody hurts.”

She predicted that in 2020, the global economy will plunge into negative territory and that more than 170 countries will see negative growth in per capita income. All these trends will further dent oil demand. 

Production cuts cannot lift prices before the pandemic is effectively contained and economies around the world begin to rebound. In fact, there is little hope that oil prices will increase markedly in the near future. This is borne out by the price of one barrel of West Texas intermediate crude oil, which has been hovering around $20 since the deal was reached.

The United States, one of the world’s three largest oil producers, did not take part in the planned cuts, but that doesn’t mean it’s in a position to stand aloof from the market. The current low prices will force it to slash production of shale oil to avoid bigger losses.

Shale oil accounts for 60 percent of total production in the U.S., with production cost is $30 per barrel, much higher than in Saudi Arabia and Russia. As long as low prices persist, American shale oil producers will gain little or no profit, thus being forced to file for bankruptcy protection or even shut down. In addition, the U.S. Energy Information Administration forecasts that U.S. crude oil production will decline by 2 million barrels per day this year. If true, this would mark the first annual decline since 2016.

In the face of reduced oil production, the administration also predicted in its April short-term energy outlook that “the United States will return to being a net importer of crude oil and petroleum products in the third quarter of 2020 and remain a net importer in most months through the end of the forecast period.” In addition, it said, “net crude oil imports are expected to increase because as U.S. crude oil production declines, there will be fewer barrels available for export.”

The United States became a net exporter of crude oil in September, but that status may soon be lost. At the same time, energy independence, an achievement the U.S. has touted with pride, may also fade away. 

Man proposes, but God disposes. Indeed.

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