Saudi Arabia has detonated a metaphorical nuclear weapon in the global oil market, blowing up prices and trade relationships with its decision to slash the cost of its own crude while ramping up output.The Saudi move was no shot across the bows aimed at Russia’s reluctance to extend and boost a deal to curb production. Instead, it was a full-on declaration of war.
Saudi Aramco aims to lift its output above 10 million barrels per day (bpd) in April, possibly as high as 11 million bpd, two people with knowledge of the matter told Reuters on March 8.
Given its current output is around 9.7 million bpd, this means as much as an extra 1.3 million bpd could flood the market next month – just as demand is taking a major hit from the economic fallout of the global coronavirus epidemic.
But pumping more oil was only one of the two barrels fired by the Saudis. The other was a massive cut to their official selling prices (OSPs) for April.
Saudi Aramco prices its crude against various benchmarks for the different regions it supplies. While the exact formula isn’t disclosed, the price moves generally reflect a combination of demand by refiners in each of the main consuming regions of Asia, Europe and North America, as well as movements in the benchmarks.
But the collapse of talks between OPEC and its allies on March 6 prompted a huge cut to the Saudi OSPs, much more than what was justified by even the current weakness in demand from refiners.
The OSP for Saudi Aramco’s benchmark Arab Light grade was cut by $6 a barrel for Asian customers, the destination of about two-thirds of the kingdom’s exports. This was the largest monthly cut in Refinitiv records stretching back to 2003.
The OSP was cut to a discount of $3.10 a barrel to the Oman/Dubai average for April, down from a premium of $2.90 for March cargoes.
It wasn’t just Asian refiners getting a massive price cut. The Saudis slashed the Arab Light OSP for Northwest Europe by $8 a barrel to a discount of $10.25 a barrel to Brent, and the United States got a reduction of $7 a barrel to a discount of $3.75 against the Argus Sour Crude Index.
When OPEC and its allies, including Russia, failed to agree to extend their output cut of 2.1 million bpd, which expires at the end of this month, or agree a further 1.5 million bpd reduction, it was always likely the Saudis would take action.
The prevailing logic was that the Saudis wanted to send a message to Russia: Extending and increasing output restrictions would have been a good idea, and that it would have been in all the producers’ interests to make this happen.
But there was nothing subtle in the eventual Saudi actions – the largest cut to the OSP in at least three decades and a threat to deluge an already swamped oil market.
Other Middle Eastern producers such as Kuwait, Iran and Iraq will have little choice but to match the Saudi price cuts, as will other exporters around the world, unless they are prepared to lose market share or shut-in wells.
It may also be the case that Saudi Arabia has more than just a lesson for Russia in mind. It may also be trying to curtail U.S. shale oil output, hoping price weakness forces producers into losses and the idling of drilling rigs.
The evidence that this will work is patchy, with the price collapse in 2014 seen as a failed attempt to crush shale producers, one that ultimately led to the OPEC and allies agreement.
While the output restrictions, agreed by OPEC and allies in November 2016 and implemented from the start of 2017, may not have delivered significantly higher prices, it did stabilise the market in a fairly broad range around $60 a barrel.
PRICES IN FREEFALL
The initial reaction to the Saudi gambit saw prices in freefall, collapsing to the lowest in four years. Brent futures tumbled as much as 31% in early Asian trade on Monday to a low of $31.02 a barrel, before recovering slightly to trade around $36.
While refiners will cheer the lower oil costs as helping their margins amid coronavirus-hit fuel demand due, it also creates some dilemmas for them.
Chinese refiners will be mindful that they are supposed to be buying huge volumes of U.S. crude as part of undertakings in the recent trade truce between Beijing and Washington.
That hasn’t happened so far. While the coronavirus outbreak can take some of the blame, that excuse will no longer wash as China finally looks to have made some domestic breakthroughs in containing the epidemic.
What still has to become clear is what do crude oil exporters do in response to the Saudi action, beyond the short-term move of also cutting prices?
Also, will importers actually buy more crude, or switch their supplier mix in response to cheaper oil? The coronavirus is still hitting demand and it’s likely that storage tanks will soon be filling up, with only China likely in a situation where it can meaningfully add to its strategic inventories.