Over a barrel: The oil industry's supply surge and demand shock

This was published 4 months ago


Over a barrel: The oil industry's supply surge and demand shock

For our free coronavirus pandemic coverage, learn more here.

The world is experiencing a pandemic-induced supply and demand shock, and nowhere is that more visible, and exaggerated, than in the oil sector.

Yet unlike the pandemic's broader economic issue of supply shortages, oil is suffering from a tide of supply at a moment of ebbing demand.

The collapse earlier this month of the OPEC+ cartel -- a loose alliance between OPEC and key non-OPEC producers led by Russia, which blew up when Russia decided not to collaborate with Saudi Arabia to increase and extend the production cuts that had kept oil supply and demand broadly in balance since 2016 -- has seen the oil price plunge from almost $US60 a barrel to below $US30 a barrel.

Saudi Crown Prince Mohammed bin Salman and Russian President Vladimir Putin. Saudi Arabia and Russia failed to renew an agreement to limit production and oil prices plunged.


Having traded as low as $US24.88 a barrel, the price has stabilised at around $US26 a barrel this week.


The split between the Saudis and Russia didn’t only take the prospect of production cuts off the table. Both decided to increase production, Russia ostensibly because it had decided there was an opportunity to put a big dent in US shale oil output and the Saudis in retaliation for the Russian decision.

The boom in the US shale sector has turned America from a net importer of energy into a net exporter and, briefly last year, into the world’s largest oil and gas exporter. In effect, the US had absorbed the production shortfall created by the OPEC+ production cuts. Their sacrifices were America’s gain.

The Saudis are following through on their threat to increase their output. Having produced as little (by their standards) as 10 million barrels a day, the Saudis are boosting production by, initially, two million barrels a day and threatening to produce at full capacity of 13 million barrels a day. That would represent an increase of about 3 per cent to global production.

Soaring inventories

There are estimates that, once the Saudis have fully ramped up, there could be a surplus of oil production of at least 6 million barrels a day.

The Russians planned to add about 300,000 barrels a day but are now equivocating as global demand for energy is shrivelling as the impacts of the coronavirus increase and spread. Demand is slumping as shut-downs and lock-downs in the world's major economies because of the pandemic impact international and domestic travel and transport.

Inventories of oil around the world are soaring to the point that some in the industry believe the world will run out of storage capacity this year.

In the near term, the over-supply of oil will have – and is having – a dramatic impact on US producers, who need a price closer to US50 a barrel to break even.

US production is being shut in, producers are already in financial distress and the entire US junk bond market, where energy companies account for about 12 per cent of the bonds on issue, is under pressure.

Energy companies represent the biggest sector of that market and there is real concern in the US that there will be a wave of bankruptcies that decimate the sector and America’s position in the global energy market.

So concerned was Donald Trump that he wanted to spend $US3 billion ($5 billion) to bail out the industry by topping up the US strategic oil reserve. That proposal, however, failed to make it into the $US2.2 trillion stimulus package Congress approved this week.

The Trump administration has also pleaded with the Saudis to reverse their decision and end the price war.

What’s a threat to the US is, ironically, producing something of a windfall for China, the world’s biggest oil importer.

With its economy frozen during the worst of the coronavirus outbreak and now thawing as factories reopen, the more than halving of the oil price represents a significant reduction in its industrial input costs.


In more normal times, China imports about 10 millions barrels of oil per day and, while its demand dropped sharply during the peak of the coronavirus outbreak, the lower oil prices – if sustained -- could mean a boost of up to $US300 billion a year to its economy.

In reality, given the global demand for China’s products from the rest of the world will slump as a result of the pandemic, it will be something significantly less than that, but still substantial.

Unless the Saudis change course, prices are likely to remain lower for longer.

They are already sending shockwaves through the entire industry sector, not just the US shale sector.

Around the world, more than $US100 billion of planned capital expenditures have already been shelved as a result of the combination of the price plunge and the pandemic.

Shelving investments

Here in Australia, Santos has put a planned $7 billion offshore gas project on ice as part of a plan to cut capital expenditures by about $600 million this year. Woodside has cut hundreds of jobs and Oil Search has slashed planned spending.

There are echoes of what happened after the oil price plunged in 2014, when the Saudis made an overt attempt to stunt the growth of US shale production, destabilising the entire sector and bringing investment in new production to a near-complete halt.

The Saudis, under Crown Prince Mohammed bin Salman, have taken a strategic decision to reduce their near-total dependence on oil while they can.

That strategy is driven by an increasingly global consensus that peak oil will be reached within about a decade as the decarbonisation of the global economy gathers pace.


The coronavirus, and ultra-cheap oil, might defer that moment marginally, but the shift to renewable technologies and the electrification of transport is an inexorable trend.

There is a limit to how much the Saudis can continue to produce in an over-supplied market, even though they are a low-cost and high-quality producer.

They need prices closer to $US80 a barrel than $US30 a barrel to balance their budget and will need to cut government spending and services and draw on their vast foreign exchange reserves to maintain the price war.

That’s not a sustainable fiscal strategy for the long term.

Search ASX quotes

Most Viewed in Business