Coronavirus

Oil to $10 or a good buying opportunity?

May 4, 2020
Oil bears continue to wreak havoc across the energy markets with crude benchmarks plunging to lows not seen in 20 years this week, having fallen more than 60% since the start of the year.

Two of the world’s largest producers, Saudi Arabia and Russia, are set to increase production dramatically in April, and set against the backdrop of the demand destruction caused by the global pandemic, the outlook for the second quarter looks no better.

Shockwaves across energy markets

If we cast our minds back to the start of March and the initial stage of the oil collapse, we will remember that Saudi Arabia failed to convince Russia to agree to deep production cuts aimed at shoring up crude prices. In turn, the Saudi-led OPEC retaliated by announcing it would start pumping crude with abandon and the next day, the kingdom lowered the price it charges for oil. This triggered the biggest one-day drop in prices since the 1991 Gulf War, with prices down 30% at one point.

As part of this price war with Russia, the Saudis will boost supply again this month and expectations are that they will also keep this up in May, along with additional cuts to their official selling prices. Meanwhile, Russia has the ability to increase output, while other middle Eastern countries like the UAE, Iraq and potentially Libya can further boost supply in the region.

Awash with cheap oil

But this is clearly to a market that does not need it. The surplus in oil markets could approach 25m barrels per day soon – the equivalent of 25% of global demand – which is a level that would overwhelm storage capacity worldwide within weeks. In this environment, similar to the last oil crash between late 2014 and 2016, the largest oil traders with access to capital and storage profit through ‘contango’ trades.

This means they buy cheap barrels in the spot market and lock in almost guaranteed profits by selling them forward in the futures markets, as oversupply pushes short-term contracts to a large discount to later-dated ones. For the oil industry in general, the capacity for storage is being tested like never before, and prices may have to fall further to force the closure of oilfields. The alternative scenario would be a lack of storage capacity forcing Saudi Arabia back to the negotiation table with Russia.

Battle for market share

With its production overtaking both Riyadh and Moscow in 2018, the US shale sector has been a wild card in the energy market, with its market share climbing to around 15% by the end of last year. However, as demand is crushed due to the ongoing pandemic, the oil price crash has seen higher cost producers like US shale oil start to suffer, even with hedges for 2020 output in place. That top position is now hugely threatened as US producers struggle to break-even, with stock prices lower and balance sheets weaker.

Different oil landscape

With the glut of supply, elevated production levels could last until June, when the next OPEC+ meeting is due to take place. The US has put pressure on the Saudis to scale back its supply surge, but this has made little impact so far. It will be fascinating to see President Trump’s next steps as oil fields and companies potentially get closed down, while Russia uses up its cash reserves to hasten the collapse of American shale. What incentive does Russia have to change course, except perhaps for sanctions relief? This seemingly unavoidable decline will in time drive prices higher, but with the demand side offering no succour either at present, it seems oil prices will continue to slide lower.

Technically, prices are deeply oversold on numerous indicators and timeframes which suggests a retracement is due. Some kind of demand catalyst and production balance is needed to avert further falls and expect to also see concerted pressure from the US to stabilise the market. Support below rests at the November 2001 low at $17.12, with another long-term cycle low at $13.75.

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