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Oil markets are plummeting as the business week opens, and it’s instructive to look at past Saudi-led price wars to see where prices may be heading.
After the collapse last week of the talks between OPEC and a non-OPEC group led by Russia, Saudi Arabia let the world know it was planning on pulling the sword out of its sheath and launching an all-out price war. From various reports, it was doing this in two ways.
First, it is planning on taking its production up to over 10 million barrels per day (b/d) from its most recent level near 9.7 million b/d. This may not seem like much, but remember that it would be doing so at a time when oil demand is collapsing because of the slowdown in economic activity created by the coronavirus. The always conservative International Energy Agency has predicted a drop in demand of 90,000 b/d this year, but that’s far less than what other analysts have projected. Several are seeing declines measured in hundreds of thousands of b/d. Note that demand generally increases every single year and a decline is extremely rare.
The second step Saudi Arabia is taking is to slash its prices. Saudi Arabia prices its oil as a differential to key benchmarks: Brent in Europe, a basket of crudes in the U.S., etc. Each month it sets a closely watched differential to those benchmarks.
Over the weekend, Saudi Aramco, the state oil company, reduced that differential by $6/b, believed to be the biggest cut ever. That is the move that is most important to consumers of oil products like diesel. So we’re talking about trucking companies and railroads.
The move smacks of what Saudi Arabia did in its 1985-1986 price war. At that time, the Saudis undertook their “netback” strategy.
The strategy was complicated. It involved setting a price formula for its crude that essentially guaranteed refiners a profit. The result was that even as the price was collapsing, which might usually lead to a reduction in output at refineries, they kept chugging right along producing plenty of product. Why not? They were essentially guaranteed a solid margin through the netback formula.
The result was plenty of crude on the market being bought by refiners and plenty of product coming out of those refineries. The result was that from a high price of about $31/barrel just after Thanksgiving 1985, the price of WTI on the then-NYMEX contract bottomed out at $9.95/b on April 1. The price of WTI did not consistently move back above $20/b until June 1987.
By slashing the differential in their price formulas, Saudi Aramco is trying to do much the same thing, albeit without the guarantee. But the differential is supposed to reflect what is going on in the market for that particular grade of Saudi crude. Across-the-board cuts of $6 to every market in the world doesn’t do that. It’s designed to make its crude cheap and attractive to refiners. And it’s a spur to have them run lots of crude and make lots of products.
That’s where it’s good news for most consumers of diesel. When markets plunge like this, refinery margins tend to – not always but often – come down also and refiners start to cut back. But in the summer of 1986, crude oil inputs in the U.S. were above 13 million b/d for most of the season. A year before, prior to the netback pricing, they weren’t above 13 million b/d for even one week.
The Saudi price formula cut very well could mean that refiners who might otherwise be facing sliding margins that lead to cutbacks – and the start of a price recovery – instead might be greeted with increasing amounts of supply as refineries ramp up to run the cheaper Saudi crude. There’s only so much of it in the world and not everybody can process it. But other price formulas will need to adjust to stay competitive.
Markets early Monday were not reflecting the idea of a market awash in products from refineries gorging on cheap crude but that’s not surprising. The first market reaction is always going to be in the price of crude because it is not just a feedstock into a refinery; it’s also a major financial asset.
At approximately 10 a.m., WTI and Brent were both down about 19-20% from Friday’s settlement, but both had climbed off their earlier lows. For example, WTI did touch $30/b dead-on overnight. But by Monday morning, it was $33.21/b, near the highs of the trading session that kicked off Sunday at 6 p.m. Eastern.
Ultra low sulfur diesel (ULSD), meanwhile, was down 16.4% to $1.158/g, a drop of 22.72 cents. If the market were to settle there today, it would be the lowest settlement since March 10, 2009, when markets hit their lowest point following the fall 2008 start of the fiscal crisis.
When will truck drivers see this benefit? Wholesale prices will be reacting to this today. The market for fuels at the wholesale level is extremely competitive and a supplier of wholesale diesel cannot afford to be uncompetitive with broader trends.Their prices will be slashed.
Retail is a different matter. Owners of retail outlets, from the mom-and-pop station to the biggest truckstop chains, are going to hold off on declines as long as they can. The spread between retail and wholesale diesel prices that is reflected in SONAR’s FUELS.USA data series will reflect just how slow – or fast – retail numbers are coming down relative to wholesale declines. In the short term, it’s likely the number in the data series will soar. These drops in market prices are practically unprecedented and retailers are not wired to make drastic cuts in their prices.
How long might this decline last? Without offering an opinion on Saudi-Russian relationships, it’s instructive to note what happened with the Saudi-led price wars of the past.
In the 1985-1986 price war, the decline from the highest settlement before the decline began and that April 1, 1986 date mentioned earlier was about 66%. It also took just five months.
In the 2014-2016 price war, when Saudi Arabia turned its guns on the U.S. shale sector (unsuccessfully), the drop from top to bottom took a lot longer, about 19 to 20 months for a drop of 75%. That saw the price of WTI decline from just over $100 at the end of July 2014 to $26.21/b on February 11, 2016.
If we take the midpoint between those two percentages, and apply a 70% decline to the recent high WTI settlement of $63.05/b, you’re looking at a price of $18.70/b as a bottom. But that’s just math; there’s a lot more to markets than that.