The short-lived price war in early 2020 showcased the global importance of Saudi Arabia's domestic oil policy

Crude oil remains Saudi Arabia’s biggest asset, and economies around the world are reliant on how the Kingdom responds to challenges. At 2019 production rates, Saudi Arabia’s known reserves are expected to last more than 50 years, and at the start of that year more than 80% of the oil produced by the state-owned energy company, Saudi Aramco, came from reservoirs that were less than 40% depleted. According to BP’s “Statistical Review of World Energy 2019” report, the cos reserves-to-production ratio in 2018 was 66.4%, compared to 25.4% in Russia and 11% in the US.

Supply & Demand

The Kingdom has worked to optimise the benefits of its hydrocarbons endowment for its citizens, balancing the volumes produced with the value of oil on international markets, weighing price and market share. In December 2016 the Organisation of the Petroleum Exporting Countries (OPEC) brokered the first oil production pact with countries outside the organisation since 2001, resulting in restrained oil output from Saudi Arabia and other members for three subsequent years. The most influential allies in the so-called OPEC+ group have been Russia and Mexico. However, while OPEC+ initially trimmed production, shale in the US recorded the largest annual increase of any country in both oil and natural gas production in 2018.

Previously planed OPEC+ output cuts were scheduled to run until the end of March 2020, with Saudi Arabia advocating for a further extension, conditional on compliance by Russia. OPEC had agreed to an additional 1.5m barrels per day (bpd) of oil cuts to the end of 2020, in addition to existing cuts of 2.1m bpd, for a total reduction of 3.6m bpd. In February 2020 Jadwa Investment reported that in light of the existing OPEC agreement, Saudi crude production stood at 6.9m bpd in December 2019 and 6.5m bpd in January 2020. When Russia rejected the proposal on March 6, 2020 Saudi Arabia had to decide whether it would allow the US and Russia to continue to erode its market share while trying to shore up prices, or endure a price downturn while ramping up its own production. On March 11, 2020 Saudi Aramco received orders from the Ministry of Energy to boost maximum sustainable capacity from 12m bpd to 13m bpd.

While the implications of these decisions by two of the world’s major oil producers would have been significant at any time, the supply shock also coincided with a contraction in demand. The global outbreak of Covid-19 resulted in major hydrocarbons consumers, from Chinese manufacturing plants to global airlines, pausing or altogether ceasing their operations as governments tried to stem the spread of the disease by imposing quarantine measures. The demand shock had early implications for Saudi Arabia, as it supplied more oil to China than any other country in 2019, with Russia coming a close second.

While for several weeks the two countries flooded markets with cheap oil, the price war seemed to be nearing an end in early April 2020, when the Kingdom and Russia alongside OPEC+ came to an agreement, pending Mexico’s approval. The plan will see output reduced by 9.7m bpd – the largest production cut in OPEC’s history – beginning on May 1 and running for two months. Then the cuts will taper to 7.7m bpd until the end of 2020 and 5.8m bpd until April 2022.

Inventories

According to Saudi Aramco’s September 2019 IPO prospectus, the company had a storage capacity of approximately 66.4m barrels at the beginning of 2019. Financial statements in the prospectus showed that the company’s inventories, including refined products and hydrocarbons, had increased in value from SR21.1bn ($5.6bn) in December 2016 to SR45.2bn ($12bn) in June 2019. Three days before the announcement, US President Donald Trump announced that his government would purchase some $2.6bn worth of oil from US shale producers, which would be placed in underground storage reservoirs belonging to the US Strategic Petroleum Reserve.

Oil Markets

In the first half of 2020 global stock markets exhibited great volatility, with large one-day falls and some significant upswings in response to government stimulus packages. On March 18, 2020, two days after Saudi Aramco’s earnings call, oil prices hit an 18-year low, with West Texas Instrument falling 18% to $21.85 and Brent crude trading at $24.52, down by more than 14%. On the same day Chevron’s share price fell 22.1%, its biggest one-day slump in 40 years, eclipsing the fall in prices during both the 2008-09 financial crisis and Black Monday in 1987. US-based Citibank predicted that Brent crude prices could fall as low as $5 a barrel in the second quarter of 2020. Although there was some recovery in oil prices the following day, by March 22, 2020, international oil companies were reporting up to 20% cutbacks in investment plans with Royal Dutch Shell’s plans pared from $25bn to $20bn, Total’s down from $18bn to $15bn and Chevron’s down from $20bn to $16bn.

Low-Cost Production

The Kingdom has key advantages when it comes to global market share. Its existing storage infrastructure around the world has allowed it to build up millions of barrels in inventory, and Saudi Aramco has among the world’s lowest production costs. The nature of the Kingdom’s geological formations, both onshore and in its shallow offshore fields, as well as its existing infrastructure and logistical infrastructure, have resulted in an average lifting cost of just SR10.60 ($2.82) a barrel in 2019, while average upstream capital expenditure on its fields stood at approximately SR17.50 ($4.65) a barrel. According to Saudi Aramco, its lifting and investments costs were lower than those of any of the world’s five major international oil companies.

Tanker Rates

Saudi Arabia’s brief decision to ramp up production in March 2020 displayed the significant influence it also has on international oil tanker markets. On March 13, 2020, a week after Russia rejected the OPEC proposal, Argus Freight reported a 213% increase in the very large crude carrier (VLCC) rate on the Gulf-to-Asia Pacific route fell to $42.21 per tonne due to a sudden influx of bookings reserving nearly all available tanker supply.

Additional Capacity

The call by the Ministry of Energy to increase output had implications for a number of Saudi Aramco’s business units and for its main oil fields. International media highlighted that bringing the Fadhili gas-processing facility on-line would allow more gas to supply power generators and industry, freeing up some 250,000 bpd of oil for export. These developments also coincided with the resolution of a dispute between Saudi Arabia and Kuwait that had implications for both countries’ oil outputs. At the end of 2019 the two countries signed a memorandum of understanding to restart hydrocarbons production in the shared Partitioned Neutral Zone, which has been inactive since 2014. Disputes saw the closure of the Khafji Joint Operations (KJO) offshore venture in October 2014 and the onshore Wafra Joint Operations (WJO) in May 2015.

Before the Covid-19 crisis and fall in oil price, production was expected to start gradually in 2020 at the two fields, which previously had a combined output of 500,000 bpd, with KJO contributing 300,000 bpd. The equity in KJO is shared by Kuwait Gulf Oil Company and Aramco Gulf Operations Company. In 1949 Chevron signed an agreement with Saudi Arabia to operate its 50% share in WJO until 2039. Chevron predicted that with the application of its enhanced oil recovery technology, WJO has the potential to become the world’s largest steamflood development. In March 2020 global media reported that a trial production of 10,000 bpd at WJO would begin in April 2020, with production expected to reach 145,000 bpd by the end of the year. Although the full implications of 2020’s demand-side shock are yet to be seen, it is evident that Saudi Arabia has the resources and capabilities to execute its long-term production and export plans.