Trump’s Coming Oil Shock: Shale Can’t Cut Enough To Save Itself

If the cut is only for a very short period, the whole meeting is about legitimizing unsold oil to extract optimum political mileage. 

President Trump, Senators from oil-producing states, and some CEOs of shale companies have cornered themselves by asking Saudi Arabia, Russia and other oil producers to cut oil production. 

The reality is this: It doesn’t matter what Russia or Saudi Arabia do. Any possible production cuts are irrelevant in the short term because no matter how deep they go, they are no match for the impact that Covid-19 lockdowns are already having on oil demand and will not raise oil prices high enough to save the U.S. shale industry.  

Furthermore, Democrats in Congress will oppose any bailout of the shale industry, leaving the U.S. shale industry to the mercy of the Coronavirus: some will go bankrupt, others will be weakened. U.S. production will experience a steep decline. 

(Notes on this chart are listed at the end of this column)

Shale Has Its Own Problems

What President Trump and Senators from the oil-producing states have not realized is that the U.S. shale oil industry has been suffering before Corona, and before Saudi Arabia increased production. They’ve been dealing with too much gas. The proportion of production of natural gas and natural gas liquid (NGLs) in most shale oil wells is high. With the increase in oil production, the production of these two materials increased significantly. Their prices collapsed to the point that natural gas was sometimes sold at negative prices at certain hubs. To add insult to injury, decline in upstream investment means that shale production will get even gassier on average. With the prices of gas and liquid gases falling, the remainder of the oil is not sufficient to generate high profit margins, hence capital flight. Banning imports from Saudi Arabia or Russia, or imposing tariffs on oil imports from them will not help the shale industry.

Crude Quality Matters

What President Trump and the Senators from the oil-producing states also do not realize is that the produced oil from shale fields is of the very sweet, light, and condensate type. Since American refineries can no longer take any additional light sweet oil, all additions must be exported. But there is little global demand for this oil. Oil will be backed out, storage facilities will be filled, pipelines will stop following, and shale oil producers have no choice but to shut in production. Tariffs on oil imports or not, the result is the same.

U.S. refiners have been forgotten in this crisis. The U.S. has to export the unneeded light sweet crude and condensates for shale, but refiners have to import the heavier and more sour crude they require from several countries, including Saudi Arabia and Russia. Crude quality issues are completely ignored. Imposing tariffs on oil imports and blocking imports all together will not help shale producers and will hurt US refiners. The situation gets worse when economic recovery starts as Corona winds down: tariffs on oil imports and blocking oil imports will increase diesel prices significantly. Diesel is the blood of US economy as most natural resources, parts, goods and services are moved via rail cars and trucks.

Effectiveness of the Cut Depends on the Goals

It is unclear yet what is the objective of the OPEC++ meeting tomorrow. But one lesson from OPEC history worth repeating: focus on what you can control, ignore everything else. If the objective is to immediately raise oil prices to acceptable levels, it is doomed to failure. They cannot control the Coronavirus. They do not have enough power to counter its impact. If the delegates are serious about a production cut, they must ignore the current circumstances and focus on market conditions after the disappearance of the Coronavirus. In this case, the objective of the production cut is to reduce storage overhang to a manageable level in the future. That is doable and under their control.

The proposed 10 mb/d production cut will not change facts on the ground in the short run: if they “cut,” they are only cutting oil that cannot be sold and would have to be shut in anyway. Yet a “cut” will exonerate Saudi Arabia and Russia from any charges that various senators might think of, while shale oil producers will continue to suffer! However, the cut could turn into something to real impact if it endures after the end of the coronavirus crisis. To matter, it would need not only to reduce the overhand, but encourage market balance (even if at a price lower than the shale guys need to stay solvent). 

To conclude, the proposed 10 mb/d cut will have a limited impact on the market in the short run, but may have a significant impact if the proposed cuts last until after Coronavirus disappears. If the cut is only for a very short period, the whole meeting is about legitimizing unsold oil to extract optimum political mileage. 

Notes on the chart. This is the most likely scenario in my view. Assuming Coronavirus impact end in June-July, oil demand will pick up, even in case of a recession, which will raise oil prices and help some production come back online.