• When the oil price war began, no one had accounted for the economic damage that would be caused by Covid-19, or how demand for oil would evaporate
  • The reality is that oil under US$30 per barrel is not sustainable for either country when oil revenue is a crucial source of income to fund fiscal spending
A worker checks the valve of an oil pipe at the Lukoil-owned Imilorskoye oilfield, outside the west Siberian city of Kogalym, Russia, in January 2016. Photo: Reuters

It has been understandably overshadowed by the coronavirus crisis, but the oil market has had a few wildly dramatic weeks. There have been more plot twists than in a soap opera, but with real-world consequences. As a result of these machinations, the oil market now faces a perfect storm of a sudden collapse in global demand and rising supply.

The month-long all-out price war caused prices to plummet to levels not seen since the great financial crisis. But this is not the first battle in the long war to control the oil market. The ultimate conclusion is all but assured to be a truce " Russia and Saudi Arabia have now agreed in principle to temporary concessions on production and a subsequent slow rebalancing of supply and demand to lift prices.

Opec's dominance in the global oil market has waned over the years, especially as technology has advanced and the United States has engineered a revolution in fracking and shale oil production. The US is now the world's largest oil producer, with around 12.5 million barrels per day. Russia produces around 11 million barrels per day and Saudi Arabia 10 million.

Until recently, the Organisation of the Petroleum Exporting Countries had fragile control of output by global producers, thus curbing production and keeping prices sustainable. That tenuous agreement fell apart in March as countries increased production to grab market share and squeeze out higher-cost producers, such as the US shale oil industry. So far, active oil rigs in the US have taken a hit, but there has been no instant impact on production.

This is hardly the first battle in the oil war. In 2014, Saudi Arabia blocked calls for oil production cuts from smaller members of Opec, and oil prices that were already in free fall plunged further. The price of a barrel eventually bottomed at about US$30 in February 2016.

Then, as now, the rig count in the US declined as the price of oil fell but output cuts didn't materialise for a number of months. This time, the drop in prices has been more severe, so US production may fall sooner. More importantly, the US is running out of space to store all its oil.

Ahead of the Russia-Opec truce, oil prices had been rising in expectation of a deal. The reality is that oil under US$30 per barrel is not sustainable for either country, when oil revenue is a crucial source of income to fund fiscal spending.

Why Saudi Arabia is likely to blink first in oil price war with Russia

Our estimates for this year are that Saudi Arabia needs the price to be closer to US$70 per barrel to meet its fiscal commitments and that for Russia, it's US$50 per barrel. Both countries had cash reserves to use in the interim, meaning they could have persevered with the price war before eventually reducing production and allowing prices to rise. Energy companies, especially in the US, do not have that luxury.

When this began, no one had accounted for the economic damage that would be caused by Covid-19, or how demand for oil would evaporate as the global economy hit the brakes. There is a realisation that production needs to be curbed sooner to restore balance to the oil market, but will the reduction of around 10 million barrels per day be enough?

During the global financial crisis, oil consumption fell by 1.5 per cent between 2007 and 2009. So far, the data is pointing to a much larger economic decline. This implies a significant near-term drop in demand; the duration of the pandemic will determine the extent of the cutback in energy demand.

A compromise and the return of an Opec+ agreement to curb production will help create a floor for oil prices, but a solid recovery would require a larger commitment to cut output. Oil prices are likely to remain constrained in the near term but the compromise on production by members of the Opec+ alliance should drive positive sentiment.

A higher or more stable oil price would filter through to the credit market and high-yield bonds, where the energy sector has a heavy weighting, as well as to the equity indices with a greater exposure to oil companies such as the FTSE 100 in London.

There are few winners in this oil war, but a reduction in production uncertainty will be one less worry for shaken investors.

Kerry Craig is a global market strategist at JP Morgan Asset Management

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