The first industries to be visibly affected by the spreading COVID-19 appeared to be travel and tourism. Then other industries began to feel the pressures of declined manufacturing activity in China. And suddenly, in the span of a week, we saw oil prices crash to historic lows. But that’s far from the only news, as Saudi Arabia and Russia appear to be in an all-out oil war, increasing their production despite severely decreased demand. So what’s going on? How did we get here? And what comes next? We’ll explore the recent events, relevant history and future possibilities here.
Remember when fuel prices bottomed out in 2015? This was because the global oil market was oversupplied. Saudi Arabia decided to produce as much oil as it could to flood markets and capture market share. Once those distribution channels were established, the plan was to ease off production and push prices up across this broader base of customers. In other words, profits could be increased.
The situation backfired, seeing oil prices crash, largely due to rapid growth of shale oil production in the U.S. Producers in America were able to ramp up production to new highs, and U.S. oil production began to rival Russia and Saudi Arabia for the first time in decades. Oversupplied markets push prices down, and fuel prices remained at the lowest level in years throughout 2016. The flood-the-market strategy was not too effective for major producers like Russia or Saudi Arabia, because higher prices translate to more revenue.
Then, in 2017, the Saudis took a new direction and expanded its policy coalition to include a larger group of oil producers. They began to cooperate with Russia and other countries by forming OPEC+ in an effort to stabilize crude prices. In other words, a majority of major oil producers coordinated production cuts to ease back supply and raise prices. These efforts were largely successful. They brought the crude market close to a balance of supply and demand in 2018. But U.S. shale oil also benefited from higher prices and kept increasing output, and the U.S. became a net oil producer in 2019.
Since 2017, OPEC+ continues to contain two of the three largest oil producers: Russia and Saudi Arabia. And they’ve cooperated with a goal of bringing stability to global oil markets. But stability may no longer be the goal.
In early 2020, global oil markets began to build a new surplus. The reason for this: COVID-19, also known as the Coronavirus. When China imposed quarantines and paused a large portion of its manufacturing, a lot of fuel consumption (mainly due to massively reduced shipping activity) rapidly fell off. Next, travel began to slow around the world. Planes and ships being large consumers of fuel, this resulted in a phenomenon called demand destruction.
When OPEC+ met in early March, it was widely expected that the coalition would continue its recent pattern of behavior and make deep production cuts to steer global oil markets towards a balance of supply and demand. But Russia surprised everyone by refusing to cut production and instead taking action to increase oil production.
What is Russia’s new strategy? They appear to be prepared to flood global markets with crude and drive prices lower. What do they have to gain from lower prices? Lower prices will hurt the U.S. shale oil producers. As their production process is more expensive than Russia or Saudi Arabia’s, their production footprint will shrink sooner than the other top producers in this war of attrition.
It’s a risky gambit. Saudi Arabia has responded with plans to also increase its oil production. This could be a measure to defend its own production footprint. Russia put Saudi Arabia in a tough spot. It can increase production to maintain the supply channels it has already established or let Russia’s aggressive tactics erode their share of distribution channels. Neither option is one the Saudis want because in either scenario oil prices will stay low. They want a balanced market and upward pressure on prices.
Look for them to stay low for quite some time. We are already seeing prices decrease at a time where seasonal factors normally drive prices up. Expect more of the same and even sub-$2 prices before this is over. Subscribe to our blog to keep an eye out for more news in our next Oil Check.