This will be a pivotal day for oil markets. The world’s largest oil producers will meet to discuss cutting their production to stabilise a devastated market due to collapsing demand. OPEC and Russia will sit down for talks on Thursday before the G20 energy ministers convene on Friday. The immediate reaction in oil prices will depend on whether a deal is struck at all, and if so, by how much production will be cut. In the big picture though, even a sizeable cut won’t stabilise the market. Here are different scenarios of what’s to come.
After the meeting between Saudi Arabia and Russia fell apart last month, both sides decided to go on the offensive, ramping up their output and flooding the market with oil in an attempt to squeeze out higher-cost producers. In the meantime, several economies went into lockdown to handle the coronavirus outbreak, which led to a dramatic drop in oil demand. Naturally, the combination of collapsing demand and rising supply saw oil prices plummet, pushing WTI and Brent as low as $19.30 and $25 per barrel respectively.
Nevertheless, low oil prices benefit no-one, especially the US energy industry that was heavily indebted before this crisis due to waves of defaults. Hence the US President used his influence to bring the two sides back to the negotiating table, promising that he has brokered an agreement for Saudi Arabia and Russia to collectively cut their production by 10-15 million barrels per day in order to boost prices.
While both nations confirmed they are willing to discuss output reductions, they were clear that they will only cut if other major producers outside of OPEC such as the US, Canada, Mexico and Nigeria, also contribute with cuts of their own.
Will they cut at all?
Probably yes. Even though there is always high uncertainty surrounding these events, all governments involved have their own incentives to push this through and stabilise market prices. Even Saudi Arabia and Russia, both of which can push prices lower for longer than any other countries given their low production costs, might not want to entirely decimate small sized US producers. If this happened, big companies would probably buy the assets of the smaller companies at a very low discount, leading to a healthy restructuring of the industry that would make US oil even more competitive in the long run.
The real question is by how much?
If everything goes smoothly with the deal and everyone chips in, it’s almost impossible to foresee a cut larger than 10 million barrels. In fact, some manipulation might have to be involved for the producers to reach a number that high.
Will a 10 million cut be calculated from today’s output levels before Saudi Arabia and Russia went on a production spree? Ten-million-barrel cuts are approximately 3 million barrels higher than the previous month’s deal and if that’s the case, then the real cut will only be around 7 million barrels.
Even if the real cut is 10 million, it still most probably won’t be enough to stabilise the market. There is no actual data available, but most analysts suggest global oil demand will take a hit of around 20-30 million barrels due to lockdown measures. As a result, the market will still be left oversupplied on a scale never seen before. In other words, this deal cannot be the only medicine that cures the oil market. Yet it will be a large bandage on the wound.
Market sentiment and upcoming scenarios
All that being said, it’s difficult to be very optimistic about oil markets. While it’s highly probable that a deal will be concluded this week, the supply cut might not be enough relative to the devastating drop in demand. As such, while prices could initially jump on the headlines of a deal, there’s a high risk that any gains will remain short-lived or that the size of the cuts could be a disappointment leading to a bearish reaction to oil. For example, if they announce anything less than 10 million barrels in cuts, prices will probably start rising, but not for long, followed by a drop. Looking at WTI, initial support may come for the $27.30 region before the focus turns to the $24 and $22 marks.
If there is no deal at all, prices will drop hard and more dramatically with the possibility of recent lows near $19.30 being overtaken.
The only scenario in which prices might surge is if the cut is bigger than expected, let’s say by 15 million barrels. WTI could break above the $29 handle to retest the $30-$31 area. However, even in this case, the spot market will still be overbought so it won’t be a sign of a healthy uptrend beginning in oil.
A consideration is that even if they agree on huge cuts, what measures will enforce these nations to truly abide by the levels they promise? The answer might be none, and as anyone who watches OPEC knows, compliance with such deals is usually an issue.
Canadian dollar could be the best proxy for oil prices
In the FX market, given Canada’s reliance on energy exports, oil prices could be reflected in the Canadian dollar and provide a proxy for what to predict in the energy markets. With the risks appearing slanted towards a disappointment from OPEC and its allies, this could imply more pain ahead for the oil-sensitive currency.