Two months ago, economic risks were serious, but WTI prices stood at $50/barrel. Fast forward to today: the world appears to be on the brink of a pandemic-driven recession, and WTI prices are below $30/barrel, with some predicting a floor below $15/barrel. How did we get here and where do we go from here? We’ll unpack two factors behind the extreme volatility in oil prices. The proximate factor is the OPEC+ supply increase. The deeper, structural factor is that the coronavirus threatens to paralyze economic activity for months and send cascading supply and demand shocks across the world. Unfortunately, we don’t have much good news. Things will likely get worse before they get better. But those who keep their heads in this time will position themselves well for the future.

The OPEC+ decision is significant, but it’s not the main event

The proximate cause of oil price declines is tied to OPEC+ shenanigans. At its March 6^th meeting in Vienna, OPEC+ (which includes all OPEC countries and Russia) failed to reach an agreement. Saudi Arabia sought to cut production, Russia refused, and now the Saudis have said they will unleash their spare capacity. All told, OPEC+ is believed to have the capacity to ship an additional 3-5 million barrels per day to the market. What’s the impact for U.S. tight oil (commonly referred to as shale)?

U.S. tight oil producers will be severely impacted if prices are depressed for a sustained period of time. Indeed, we believe that is a primary reason for the production cut: the Russia-Saudi Arabia spat is likely just dramaturgy, and their real target may be U.S. tight oil (and Electric Vehicles, although we won’t get into that). Russia and Saudi Arabia are thought to be the world’s lowest cost producers. Russian oil can generate post-tax cash flow at $10/bbl, according to OIES. Saudi Aramco claims post-tax breakeven costs of below $10. Since Russia and Saudi Arabia’s breakeven costs are below U.S. shale, their strategy of flooding the market with volumes could work.

It’s not clear, however, if Saudi Arabia and Russia can sustain low prices for a long time. Saudi Arabia’s “social breakeven price” (i.e. the breakeven cost after all domestic subsidies are distributed) is about $83/barrel; Russia’s fiscal rule targets prices at $40/barrel. Those estimates do not account, however, for any coronavirus-related fiscal expenditures that both governments will likely be forced to undertake. So even if Saudi and Russian producers are able to maintain oil prices at $20/barrel, the Saudi and Russian governments might be unwilling to risk depressed prices.

Given the economic, fiscal, and social constraints facing the Kingdom, most analysts believe Saudi Arabia is more likely than Russia to seek a truce. As Jeff Currie notes, however, Russia’s Soviet-era brownfield production in landlocked west Siberia could be exposed if it suffers storage constraints. It’s an open question who will blink first – or if Mohammed Bin Salman and Putin may be seeking low crude prices for non-economic reasons. The price war could last a week or a year. 

The Putin/MBS price war will almost certainly hurt U.S. tight oil, perhaps even severely. The scale and duration of the price war will determine the levels of pain. Still, even a prolonged price war could, in the medium term, make the U.S. oil and gas sector much more efficient and competitive. We expect integrated players (and possibly private equity funds) to consolidate the Permian, rationalize export terminal capacity, and leverage contiguous acreage and economies-of-scale. All of these steps could drive down sectoral breakeven costs. Furthermore, the sector could also become more creative in unpredictable ways: we’ve heard interest in a crude oil export terminal on Mexico’s west coast. U.S. tight oil has already adopted most of the lowest-hanging cost improvement techniques and technologies since the 2016 bust threatened the industry, but there’s still room to run. And, finally, shale is short-cycle and could quickly resume under more favorable market conditions. U.S. shale could very well become more competitive in the medium term, although short-term pain appears highly likely.

We Are All Epidemiologists Now

Speaking of unpleasant things, we need to talk about the coronavirus. We are not public health experts, but we recognize that the public health crisis is driving energy market movements. If you are not reading about the coronavirus every day, then you will likely fall behind your competitors. The coronavirus is the new paradigm: oil demand has fallen by 20-35 million barrels per day amid physical distancing requirements. COVID-19 will determine energy market outcomes until it is defeated through a vaccine, treatment, or containment.

While the COVID-19 coronavirus is known to have originated in China, scientists have not yet determined other basic characteristics of the disease. The case fatality rate (CFR, or the probability of mortality if the disease is contracted), transmission mechanisms, incubation periods, and possibility of asymptomatic spread are not known with any precision. Older patients and individuals with preexisting conditions are most at risk. The CFR is thought to vary from 0.5% to 3.5%, with most experts pegging it at close to 1.0%. Importantly, the CFR and the prevalence of cases are linked. If the number of coronavirus cases spikes, hospitals could run out of beds and ventilators, and the CFR could rise. To avoid overwhelming the healthcare system, state and local governments and the private sector are cancelling mass gatherings.

What’s the projected course of the virus? Epidemiologists have forecast a wide range of outcomes: the best-case scenario is that we experience two months of severe economic and social disruptions, with warmer weather, behavioral changes, and prudent public policy limiting the downside events. That’s the view of Scott Gottlieb, the former Food and Drug Administration commissioner. Others are more skeptical. German Chancellor Angela Merkel has warned that “up to” 70% of all Germans will be “exposed” to COVID-19.

COVID-19 and oil markets: more questions than answers

It’s important to retain some humility and acknowledge uncertainty, given that even epidemiologists disagree about the spread of the virus. Nevertheless, we think some conclusions and key questions are worth noting.

· Oil demand will likely remain suppressed for at least several months. Indeed, 2020 total oil demand will likely decline y-o-y, barring an unexpectedly rapid resolution of the coronavirus. If the virus is not contained, the human consequences will be incalculable and the economic costs – including to energy demand – will be severe.

· Pay attention to floating storage levels. Once floating storage capacity is exhausted, prices could fall sharply.

· Platts estimates world storage levels could be exhausted by early May. With world demand down by 20-35 MMBPD, even a 10 MMBPD production cut would only delay a storage max-out.

· Local storage capacity will prove increasingly important. Some producers will shut-in due to physical (rather than financial) constraints if they are unable to move their products to market.

· Companies and individuals may permanently decrease their demand for jet travel, with implications for lighter-end products. Many companies are beginning to rethink the purpose of conferences and long-distance travel for face-to-face meetings. Depending on the duration of this crisis, businesses may permanently scale back all non-essential travel. Similarly, consumers may permanently reduce their demand for jet travel amid contagion fears as well as climate change-related social pressure.

· Oil supply could also fall steeply if the coronavirus spreads, however. Are oil producers in West Texas insulated from the coronavirus? Moreover, it’s not clear if Russia, Saudi Arabia, or other oil producers can sustain production if – or when – the coronavirus begins community spread within those countries. Saudi Arabia and other Gulf countries are extremely dependent on foreign migrant labor; several million Central Asian migrants work and live in Russia. Not even offshore rigs are invulnerable to coronavirus disruptions: a Norwegian tested positive for the coronavirus on an offshore platform.

· It’s not too soon to think about what happens after the crisis is over. We expect that illiquid, uncompetitive producers will struggle to survive the downturn and will be ripe targets for takeover. Occidental Petroleum, which acquired Anadarko near the peak of the market, is an obvious takeover target. Large, liquid Majors and Supermajors will likely seek to expand into contiguous acreage and acquire assets at fire-sale prices.

Let’s Roll

This is a very difficult period in U.S. oil and gas history. Competitors in Russia and Saudi Arabia appear to be exploiting the chaos of the coronavirus to press commercial advantages, and the virus itself poses an immensely serious threat to the world economy. Still, the U.S. oil and gas sector can survive these days and become more efficient. The uncertainties of the coronavirus are extremely serious, but it’s important to keep a level head. Keep calm and wash your hands.