Navigating headlines these days is like crossing a live minefield with tanks firing from either side, and a tornado sweeping the path. If it wasn't enough to see countries closing down their borders and going into lockdown -- while their governments announce versions of fiscal and monetary packages in the billions -- we now have U.S. oil companies slashing capital expenditures as fast as the central banks are printing out dollars to save their weakening economies.
WTI oil is trading below $30 a barrel, as the oil market is faced with collapsing demand from the coronavirus-imposed lockdown globally, coupled with a surge in supply from all the major producers as they engage in a who-will-blink-first contest; we have a double-whammy!
Over the past five years, U.S. oil companies have taken the majority of oil market share as U.S. shale helped overall production to grow from around 8,000 barrels per day in 2012 to 13 mbpd by February 2020. As U.S. shale kept growing, it was the Organization of the Petroleum Exporting Countries -- mainly Saudi Arabia -- that felt the brunt of this market grab as it kept cutting production to support higher oil prices.
Russia has been growing steadily, but its oil production has been more or less around 10 mbpd. Needless to say Saudi Arabia was tired of pleading with Russia and other non-OPEC/OPEC members to cut along with them to artificially support oil prices. It was a fake market as we had already taken about 2 mbpd out since last year. As the world goes into lockdown, travel and manufacturing demand have come to a halt, there are vast amounts of barrels of unclaimed oil lying around. Nobody wants it; there is just too much. Even as China tries to come out of its lockdown slowly, it demand is still slow compared to the old growth rates. There is simply just too much oil. Hence, prices are falling way beyond fundamentals and economics. Commodities work like that, as there is no ceiling or floor; if you need electricity you will pay whatever you have just to have it, and vice versa.
U.S. shale companies, given their massive debt burden and credit leverage, need about $40 to $45/bbl. of WTI to be profitable, and in some cases to dig new wells and complete them. At these prices, they are just turning the lights off. We saw ExxonMobil announce that it was evaluating significant near-term capital reductions. Pioneer Natural Resources, (PXD) , one of the best quality Permian shale oil producers, slashed on Monday its 2020 spending down to $1.6 billion to $1.8 billion from $3 billion to $3.3 billion. It is also reducing its rig count from 22 down to 11 rigs and now will have flat year-over-year production. EOG Resources (EOG) , another U.S. independent, announced cutting their 2020 capex to $4.3 billion to $4.7 billion, down 31% from midpoint of previous guidance, also targeting flat year-over-year production. This is the severity and state of the U.S. shale drillers; it is easy to pump and produce more, but also easy to take their foot off pedal and completely slowdown. It is for this reason U.S. shale oil is so sensitive to WTI oil prices. Russia and Saudi Arabia know this.
Perhaps what those nations underestimate, however, is how resilient they can be, as it will not be easy to flush them out entirely, just like 2014 when Saudi first tried the strategy of grabbing market share. Due to the efficiency of shale drilling and mature U.S. credit markets, they have a lot of firepower to maximize production at times at negative operating cash flow even. Also, what most investors tend to forget is U.S. shale companies going bust does not necessarily mean no more U.S. oil. As companies go into Chapter 11 or file for bankruptcy, the asset can continue being operated by a third party as they go into administration. This is something that surprised many of the other producers back in 2014 as well.
So how bad are these prices today? According to S&P Global Platts Analytics, using an average WTI price of $35 per barrel for 2020, U.S. crude production would drop to 9.75 mbpd this year, from a current reference of 12.95 mbpd and $54 per barrel WTI. That is a decrease of 3.2 mbpd.
This would tighten the markets significantly if this is where prices are towards the end of the year and impacts of the virus wear down. Using $50/b WTI for 2020, US production can drop to 11.8-12 mbpd, with the loss being around 1.4-1.6 mbpd. This is assuming some natural decline rates, well efficiencies and well completions. The only area of growth is Permian as other areas will be in severe decline. Saudi Arabia has ramped up production to 12.7 mbpd from 9.7 mbpd ~ an increase of 3 mbpd. This just means that for those excess barrels to be soaked, WTI prices need to be sub $40/b for longer. As rig counts decline and frack spreads fall, we will see less and less U.S. production.
Today, the big unknown factor is demand, as no one knows how quickly the virus will die down, and when life return back to normal. One can use China as an example, as it was the first to suffer this lockdown. Then, 45 days after that nation's drastic measures, some sort of normalcy is returning, but still, nowhere close to running at full steam. We could see a demand slowdown through through the second quarter, even.
There seems to be chatter that the OPEC+ agreement might be back on the table. It seems like a low likelihood, as Vladimir Putin said Russia had ample reserves to last with oil prices between $25/bbl to 30/bbl. for next five years. He is too methodical and strategic, and will never be seen to give in, especially as this suits Russia to see U.S. oil companies fall. It remains to be seen whether Saudi blinks, but this will be more about honor than financials. Their future relies on an economy diversifying away from Oil, and their fiscal breakeven relies on an Oil price closer to $80 barrel, regardless if the actual cost of production of their oil is in single digits.
Oil prices will only rally once all this excess inventory is sucked away, even if once the world comes out of its lockdown mode and starts working again.