Explaining Saudi Arabia’s Oil Price Drop

Usually, when Saudi Arabia issues its official selling prices (OSPs) for the upcoming month, all the Middle Eastern crude exporters take notice and follow suit. Yet what happens if the Saudi national oil company Saudi Aramco delays a decision well beyond the usual timeframe (first 5 days of the preceding month) and then surprises analysts with a price drop? According to its official statement, Saudi Aramco was delaying the release of September OSPs because of the Islamic religious holiday Eid al-Adha which will end this Saturday. On Thursday evening, however, Saudi Arabia surprised the market by issuing its September OSPs. The last time Saudi Aramco took its time to deliberate it flash crashed its April 2020 OSPs by $5-6 per barrel, effectively starting a price war the impacts of which are still being felt all around us.

The oil market has undergone quite a change since April though - the coronavirus is now a firm reality of everyday life and some oil firms have learned to live with; demand in some parts of Asia such as South Korea and Europe has been coming back online, while India, Latin America, and others are struggling to come out of lockdown. Meanwhile, OPEC+ production quotas are less stringent than they were just a couple of months ago. All of that combined has brought producers to a new decision point - they need to confront weak refinery margins as the immense quantities of stored crude are being digested by refiners. Cutting production is no longer an option as the majority of OPEC+ countries seem to be taking a dim view on prolonging the curtailments now, when the price of crude hovers above $40 per barrel.

Graph 1. Saudi Aramco OSPs for Asia (against the Oman/Dubai average).

Source: Saudi Aramco.

That being said, what was there to expect? Most (if not all) industry watchers were expecting Saudi Aramco to cut down its September OSPs, for the first time since May. OPEC+ producers have been pumping 2mbpd more crude into the market than they did in May as the agreed collective production cut has entered its 2^nd phase, with the output quota consequently dropping from 9.7mbpd to 7.7mbpd in August-December 2020. Moreover, with crude prices already at satisfactory levels for some of the OPEC+ producers (e.g: Russia's breakeven at $42 per barrel), the overall compliance might weaken in the upcoming months. Field maintenance works and other rescheduled commitments are already done and CAPEX cuts constrain any further ones.

The gradual rebounding of OPEC+ production was in one way or another to be expected, but no one could foresee the sudden plummeting of Chinese demand in the second half of July. The drop had two root causes: floods across China with a subsequent rise in crude inventories which surged to a new high of 889.35 MMbbls in the week ended July 26, according to Kpler data. With crude stocks almost 50 MMbls higher than a month ago, Chinese refiners have decided to first digest their own inventories and curb new purchases to counteract such depressed demand. India continues to struggle with lockdowns and is expected to overcome the COVID-induced demand drop by the end of this year. All in all, the Saudi September OSPs for Asia-bound cargoes were expected to drop by $0.7-$1 per barrel month-on-month, whilst the European OSPs were expected to see an even steeper decrease of almost $2 per barrel compared to August 2020.

Graph 2. Saudi Arabia, Iraq and UAE Crude Exports in 2017-2020 (million barrels per day).

Source: Thomson Reuters.

Saudi Aramco's September OSPs have surprised Asian customers as the extent of the price drop was roughly half of what was expected, ranging from -30c per barrel for Arab Heavy to -60c for Arab Super Light. This is all the more surprising as the prices for European customers both in NW Europe and the Mediterranean were fully in line with market expectations, with NW Europe prices falling by -$1.8/-$2.8 per barrel and Mediterranean differentials dropping by -$1.1/-$2.5 per barrel. In terms of grade preferences across all continents, the lighter the crude the bigger the month-on-month decline.

Dubai struggled through July with the Dubai M1-M3 spread (the difference between front-month cash and same-month futures), one of the main benchmarks of the Asian sour market, dropping from a high point of +$1.3 per barrel in early July into negative territory (-20 cents per barrel) by the month's end. As much as the Dubai M1-M3 is an important benchmark of the Asian market, Urals prices in Europe are a vital indication for any competing producer. Urals has plummeted in July amid weak refining margins and gradually increasing Russian production, with Baltics Urals dropping below Dated Brent where it should be under normal conditions. Thus, Saudi Aramco prefers to follow the market line in Europe and elsewhere whilst it continues to hold firm on the Asian front, despite rumors of China going big on discounted U.S. crudes in the upcoming weeks.

Graph 3. Urals Baltics and Mediterranean Quotations in 2020 vs Dated Brent (USD per barrel).

Source: S&P Global Platts.

Even though Saudi Aramco has decided to whistle over the current state of the market, at some point it will have to take a proper stance in its ceaseless balancing act of increasing production and hoping for a hike in crude prices. The reckoning can be delayed but cannot be avoided for good.

Other Middle Eastern producers, such as Iraq or Kuwait, would be caught on the wrong side of the hedge if they were not to fall in line - their dilemmas are just as actual as those of Saudi Arabia. Looking further ahead, one can fairly safely assume that the remaining part of the year will see weaker Middle Eastern differentials.

Increasing production and assumedly weaker OPEC+ discipline will pressurize Saudi, Iraqi or Kuwaiti differentials even after China processes some of its plentiful crude in storage and overall Asian refinery margins improve. With increased production rates, quality discrepancies would reappear - at the moment, the Asia Pacific OSP difference between Arab Light and Arab Heavy is a mere 10 cents per barrel whilst 2 years ago it was a whopping 3 USD per barrel. By no means should this mean that oil prices would remain where they are now, the oil curve still has plentiful surprises to offer. With the easing of OPEC+ production curtailments and the relevant oil companies' fatigue of underproducing against a reasonably manageable $40-45 per barrel oil environment, there remain very few structural factors that can maintain the current differentials' anomaly.