Law360 (June 30, 2020, 5:07 PM EDT) --
For many market participants, this is welcome news, given the significant uncertainty facing oil markets amidst the backdrop of a sustained period of global oil oversupply, demand reduction related to COVID-19, and uncertainty in the global economy. The production cut extension also gives markets further confidence that Saudi Arabia and Russia are committed to stabilizing oil markets and enforcing compliance within OPEC+.
Now, market participants are keenly asking three questions:
- Will the détente between Saudi Arabia and Russia continue to hold?
- Will U.S. shale producers react by ramping up production or following suit?
- What indicators will OPEC+ monitor to gauge how U.S. shale producers are responding to increasing oil prices?
How We Got Here
On April 12, OPEC+ agreed to a record oil production cut to help stabilize oil markets. OPEC+'s deal in April, which jolted the oil markets, set the following production cuts:
- 9.7 million barrels per day production cut in May and June 2020 (two months);
- 7.7 million barrels per day production cut from July to December 2020 (six months); and
- 5.8 million barrels per day production cut from January 2021 to April 2022 (16 months).
Oil prices have responded in kind, steadily increasing since the mid-April plunge forced oil futures contracts below zero and saw spot prices sink to levels last seen decades ago. However, as the June meeting approached, market participants feared that any premature production increases could jeopardize the substantial progress already made.
With the July 1 trigger for production increases looming, Saudi Arabia and Russia agreed at the start of June to extend production cuts for an additional month, delaying any production increases until August.
In anticipation of this extension, a dispute broke out among OPEC+ members regarding compliance with the April deal, a longstanding source of frustration for many countries. Saudi Arabia and Russia argued that countries that have not fully complied with the April deal should immediately implement the agreed-upon production cuts, with deeper production cuts to follow to make up for earlier noncompliance.
Mexico declared that it was unwilling to participate in cuts from July, instead encouraging members in noncompliance to take action. As June 6 approached, market participants eagerly watched to see whether OPEC+ would remain unified, especially in light of the recent détente between Russia and Saudi Arabia.
June 6 Decision
Recognizing the fragility of the oil markets and the need to provide stability, OPEC+ ultimately reached a deal on June 6, which modifies the schedule of production cuts set in April as follows:
- 9.7 million barrels per day production cut in June 2020 (one month);
- 9.6 million barrels per day production cut in July 2020 (one month);
- 7.7 million barrels per day production cut from August to December 2020 (five months); and
- 5.8 million barrels per day production cut from January 2021 to April 2022 (16 months).
In addition to the continuation of the current production cuts through July, the deal also demonstrates OPEC+'s increased focus on member country compliance with the agreed reductions. OPEC+'s Joint Ministerial Monitoring Committee, or JMMC, which monitors oil market conditions and member compliance, will meet monthly to review compliance with agreed production quotas.
The JMMC met again on June 18 to consider developments in the market. The JMMC noted that production cuts taken in May only amounted to 87% compliance with the agreed-upon schedule, and stressed the importance of 100% compliance from all countries.
Countries that have overproduced their quota in May and June will be required to compensate with corresponding reductions from July to September, and must submit schedules detailing their plans for full compliance and compensation for previous overproduction.
The next OPEC+ meeting is scheduled for Nov. 30; however, the group is prepared to meet sooner if circumstances warrant. Members will review the agreement for potential extension in December 2021.
Relations Between Russia and Saudi Arabia
Russia considers Saudi Arabia to be the key player in all OPEC+ decision-making. Currently, Russia's position and interests are aligned with Saudi Arabia. However, this may not last for long, especially after Russia's failed attempt to act as an independent key market driver for oil prices earlier this year.
Critically important to both countries' cooperation is the relationship between the oil price and government finances in Russia and Saudi Arabia. To balance its budget, Russia needs the price of Urals oil to stay at or above $42.50 per barrel. In contrast, the Russian government believes Saudi Arabia needs a markedly higher $80 per barrel price to fully fund its government spending and investment programs.
If the oil price stabilizes above $42.50 per barrel, there is a possibility that Russia may stop strictly enforcing its share of production cuts, all the while maintaining the appearance of acting in alignment with OPEC+. This would likely be motivated by a desire to replenish its financial reserves after the significant hit due to the COVID-19 shutdown on its economy and recent lower oil prices.
The Position of U.S. Shale Producers
Market participants are anxiously awaiting U.S. shale producers' response to the modest stabilization in oil prices. While much attention has already focused on how operators have slashed capital expenditures, reduced operating expenses and curtailed production, it is likely that OPEC+ members are also closely monitoring three additional indicators for how U.S. shale is responding to the uptick in oil prices, including:
- U.S. horizontal rig count;
- Frac spread utilization rates; and
- Inventory of uncompleted wells.
OPEC+ is likely satisfied by the significant production declines already seen in U.S. oil production, which has fallen from 13.1 million barrels per day in January to 11.2 million barrels per day in June. The key question for OPEC+ becomes whether this downward trajectory will persist.
The count of rigs targeting shale formations through horizontal drilling in the U.S. stood at 701 rigs at the start of 2020. Now, the same count has reached a historic low of only 246 rigs, representing a substantial 65% decrease in new horizontal drilling in the United States. Operators are pulling on all levers to conserve capital in the current environment, and this is reflected in the significant reduction in drilling activity.
Another key metric of interest for OPEC+ is the number of drilled and uncompleted, or DUC, wells, and whether operators are willing to complete these wells to spur oil production and gas production. The most prolific oil producing basin in the United States, the Permian Basin, has seen no change in the DUC inventory from January until today, with approximately 3,500 wells remaining uncompleted.
Over the past months, operators appear unwilling at current prices to convert this inventory to production. Reinforcing this view, the frac spread count — an index which tracks the number of spreads that hydraulically fracture wells in the United States — has dropped from approximately 400 spreads one year ago, to 275 spreads as recently as March, to approximately 60 in June.
Operators are not completing wells in the current environment, and new production is not coming online. And while OPEC+ is likely willing to allow U.S. shale producers to enjoy the benefits of higher oil prices so long as the rig count remains depressed, it remains to be seen how OPEC+ would respond to an increase in the rig count.
So production is declining, the DUC inventory remains stable, wells are not being completed and the rig count remains at historically low levels. From OPEC+'s perspective, there is little in the way U.S. shale producers have responded thus far that would motivate an immediate policy shift. But due to the dynamic nature of the industry, things are likely to change quickly, and OPEC+ will no doubt be watching developments closely.
What May Be Next
Key considerations in the coming weeks and months that may determine the success of the OPEC+ deal include:
- How OPEC+ manages the relationship between short-term prices and the futures curve;
- How short-term oil demand responds as COVID-19 related movement restrictions begin to ease;
- Whether global crude oil inventories start to diminish;
- Whether OPEC+ members comply with agreed production cuts;
- How long Russia and Saudi Arabia remain aligned;
- Whether countries pursuing their own national interests, like Mexico, destabilize OPEC+'s unified approach; and
- How independent producers in the United States respond to the recent increase in oil prices, particularly amidst the Texas Railroad Commission's recent decision on May 5, 2020 not to curtail Texas oil production.
How Operators Can Leverage the Recent Stabilization in Oil Markets
- Pursue opportunistic M&A, utilizing dynamic pricing mechanisms;
- Assess hedging strategies and consider collarless hedges;
- Plan for short- and medium-term liquidity scenarios;
- Pursue potential restructuring options; and
- Leverage material agreements to mitigate risk.
Denmon Sigler is a partner and Scott Shelton is an associate at Baker McKenzie.
Baker McKenzie partners Stanislav Sirot and Luis Gomar and associate Emily Nash also contributed to this article.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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