Explained: How Covid-19 Fallout Pushed OPEC+ Towards A Historic Oil Deal

On 14 January this year, when the total number of confirmed cases, worldwide, for the coronavirus were 60, Brent Crude, which serves as a major indicator of crude oil prices across the globe apart from the West Texas Intermediate (WTI), was trading at $64. A week later, it touched this year’s high of $65.2. By 1 April, it was trading at less than $25.

WTI too followed a similar trajectory going from this year’s high of more than $58 in January to $20 by March end. Both Brent Crude and WTI started falling after the coronavirus outbreak took over global news cycles with dented consumer sentiment and a consequential slowdown.

What exacerbated the fall was the lockdown issued by national governments across the world, starting with China’s Wuhan in late January. By the last week of March, more than 40 per cent of the world’s population from the United States, Europe, and India amongst other nations was confined to their homes.

Thus, with road transportation, which made up 50 per cent of the Organisation for Economic Co-operation and Development (OECD) nations’oil demand in 2017 and halted planes, trains, and factories in many parts of the world, the demand for oil went for a toss.

In any sane economic ecosystem, the supply follows the demand. However, in the OPEC+ meeting on 6 March in Vienna, the oil coalition, responsible for more than half of the world’s oil production, fell apart. Together, Russia and Saudi Arabia constitute almost a fifth of the world’s crude production.

Saudi Arabia was not willing to go for production cuts without Russia, and with the latter’s energy minister choosing to walk out of the meeting, Saudi Arabia decided to operate its oil taps at full capacity, increasing its production to 12.3 million barrels per day from 9.7 million barrels. Russia added another 300,000 barrels to its output.

What both nations did not factor in was at least a 20 per cent global demand reduction for oil, and thus, two artificial calamities, coronavirus and oil, flooded the world. To put things in perspective, the average daily consumption of oil, globally, stands at 100-odd million barrels.

The issue behind Saudi Arabia choosing to flood the oil market was the inability of OPEC+ member states, especially Russia, to support Riyadh in production cuts. As an average percentage of the total OPEC+ cuts, Saudi Arabia and Russia’s respective share stood at 33 and 14 per cent between January 2017 and June 2018, at 65 and 11 per cent between December 2018 and November 2019, and at 54 and 13 per cent between December 2019 and February 2020.

In December 2019, of the pledged production cuts amongst the OPEC+ members, Saudi Arabia’s pledged production cut stood at 489,000 barrels a day in December 2019. For the 10 member states of OPEC+ but not a member of the OPEC, the combined pledged production cut was 514,000 barrels a day with Russia leading at 300,000 barrels per day output cut.

Another reason was faltering compliance with the production cuts within the OPEC+. In January 2020, only 6 of the 20 member states (barring Libya, Iran, and Venezuela) of OPEC+ were adhering to the production cuts.

Saudi Arabia slashed its production by 900,000 barrels per day against the committed 489,000, with Angola, Kuwait, Algeria, Congo, Oman, and Azerbaijan also cutting their output more than previously committed. Russia, against a pledged cut of 300,000 barrels, only managed to decrease its production by 234,000 barrels per day, thus further irking Riyadh and resulting in the breakdown of the coalition on 6 March.

A month later, both nations have gone back to the drawing board, assisted by President Donald Trump. On Sunday (12 April), the OPEC+ nations reached a deal, more than a month after the Vienna talks.

As per the agreement, the 23 member states of OPEC+ have decided to reduce the output by 9.7 million barrels per day. While the initial commitment was to reduce the production by 10 million barrels per day, there were unconfirmed reports of production cuts of more than 15 million barrels being deliberated.

After May and June, the production cut will be 7.6 million barrels per day, and starting 2021 until 22 April, at 5.6 million barrels per day. Saudi Arabia, as per the agreement, will be producing 8.5 million barrels per day against the 12.3 million barrels they are producing now.

The US, Brazil, and Canada have committed to an additional 3.7 million barrels in cuts and other G20 nations have opted for a voluntary cut of 1.3 million barrels per day. However, the commitment merely exists on paper as the cut is a virtue of falling oil prices alone.

Firstly, the global demand for oil is far greater than the cuts. For a demand reduction that exceeds 25 million barrels per day (35 million barrels as per some reports), the cuts fall short. Therefore, in the short-term, the prospects of Brent Crude and WTI going back to their yearly highs look minimal. For the markets, the OPEC+ solution could prove equivalent to using a toy gun in a gang war.

Two, there is no clear indicator as to when the demand will be back to the pre-Covid-19 levels. Even if the states of Europe, the US, and India were to open their economies in May, the warranted behavioural changes would have an impact on oil consumption. The aviation industry, tattered by the outbreak, may not consume oil as they previously were, thus further prolonging the lack of demand.

Three, the next challenge for the OPEC+ states would be when the global economy goes back to normal, say a year from now, would be to decide on the market share. As stated above, the oil market warrants voluntary production cuts to keep the prices afloat.

However, given the utility of oil, in a world migrating towards renewables, is decreasing faster than the oil itself, Saudi Arabia may not be able to lead by example anymore as it did early this year. While this deal does offer temporary relief to the member states, far bigger problems on the front of production cuts will require addressing once the world goes to the pre-Covid-19 way of life.

Lastly, the world is running out of storage spaces for oil. By the time the OPEC+ begins implementing the production cuts, storage would be an issue.

Already, China and India are filling up their strategic reserves, but eventually, even they shall run out of spaces. Most analysis predict physical and floating storage capacity to be full by Q2 of 2020 if the demand falls by 20-25 per cent until June, and therefore, the 9.7 million barrels may prove to be a band-aid for a bruise that warrants a surgery.

There are some upsides to this historic deal as well.

Firstly, the production cut will come as a relief to smaller players in the West, especially the US, where negative oil prices had been witnessed. Wyoming Asphalt Sour, a dense oil used to make paving bitumen, was being sold at negative prices in March. Thus, producers were actually paying the buyers to get rid of the oil. Another crude from North Dakota went as low as 50 cents to a barrel, before the price was revised to $1.50.

Two, it gives the smaller petrostates time to work out a revised budget based on the new prices. Saudi Arabia requires the barrel to trade at $80 to balance its budget while Russia balances it at $42. However, both states have significant foreign reserves to absorb the loss in prices, unlike the smaller states.

For instance, Ecuador planned its national budget at $51 for a barrel, Iraq at $56, and Nigeria at $57. Even at $40 a barrel after the cuts, the national budgets for the smaller petrostates would warrant revision, and this deal buys them a significant amount of time.

Lastly, it keeps the coalition against cheap oil alive.

Cheap oil, over a long period of time, has consequences for smaller petrostates and the employment there, and the growing market of renewable energy resources. While cheap oil may benefit countries like India and China, who are going to use the fall in prices to sponsor their fiscal deficit in this slowdown, it does add to the climate stress which could prove to be a far bigger catastrophe than a $10 price increase for a barrel of oil.

The OPEC+ coalition needs to survive, not for the climate, but itself. For Saudi Arabia, which relies on crude oil for two-thirds of its government, and wants oil to trade higher in order to diversify its economy, a failed coalition can have consequences beyond the markets, given the nation’s geopolitical importance for the West when it comes to containing Iran.

As Comrade Dyatlov would have put it; 9.7 million barrels — not great, not terrible.