Necessary, not Sufficient
By: Dr. M. Ray Perryman
Published in syndication April 15, 2020
Since the beginning of 2020, oil prices have fallen from the upper $50s per barrel to $20 or less. Needless to say, the fallout has dramatically hit major production areas, including those in Texas. A recent agreement between OPEC, Russia, the United States, and other nations is a clear step in the right direction, though it won't solve the problem immediately.
Oil markets are in such turmoil due to the combination of (1) plummeting demand as economies around the world shut down due to COVID-19 and (2) rising supply (and threats of even more) due to the collapse of talks earlier this year among major global oil producers attempting to bring discipline to the market. The inevitable outcome of falling demand and rising supply is declining prices. As I wrote at the time, neither Saudi Arabia nor Russia could remain economically viable at these levels.
The recent deal involves 23 countries agreeing to reduce the global supply of oil by 9.7 million barrels per day, which is about 13% of world production. In addition, new wells in the US and elsewhere won't be brought online, enhancing the effect of the agreement by additional millions of barrels in the not-too-distant future. (Newly fracked wells often exhibit high production initially but decline quickly; thus, fewer new wells drop production rapidly.) The US was actively involved in brokering the deal.
The agreement is not an immediate solution. The supply reductions, while substantial, are dwarfed by the demand decreases, leaving a glut. In March, demand dropped by 20 million barrels per day. The International Energy Agency is projecting that in April, demand will be 29 million barrels per day lower than a year prior and down to a level last seen in 1995, with May little better. A massive shutdown around the globe obviously has profound short-term implications.
With these declines and storage facilities essentially full, the recent agreement doesn't balance the market. However, it does keep the supply overhang from getting massively worse. As the economy begins to recover once social distancing and travel prohibitions can be relaxed, oil markets can normalize more quickly.
Demand won't return all at once, but as long as we don't have to shut down the economy again, it shouldn't take long to recover around 10 million barrels per day (roughly 40% of the loss after the virus). With the production cuts, that's enough to get to an orderly market and support the beginnings of a resurgence for the industry.
There was no feasible deal that could have resulted in an immediate balancing of the oil market given the current environment. The recent agreement is not sufficient but is clearly a vital and necessary step.