Rising production and collapsing demand due to the Covid-19 pandemic is causing an unprecedented glut in the oil market.
As a result, we are currently witnessing a pronounced supply and demand shock that has sent oil prices to a multi-year low.
At the current pace of production, global oil storage capacity will be filled by the end of the second quarter.
This situation is already causing price pressures at oil wells, where oil producers are finding it increasingly difficult to sell their inventories.
As a consequence, energy stocks have been the worst performing year-to-date in global equity markets, while credit spreads of sub-investment grade energy companies have widened dramatically, signaling increasing concerns about the solvency of the sector.
The major oil producing countries have now agreed to cut production to try to avert the crisis. But will their action be enough to balance the oil market? And what are the implications for investors?
An unprecedented drop in oil demand
The Covid-19 pandemic has led to the implementation of rigorous measures globally to contain the spread of the virus.
Travel restrictions, social distancing and stay-at-home orders have reduced global oil demand by an estimated 5.6 million barrels per day (mb/d) in the first quarter of 2020 relative to the first quarter of 2019. This situation is expected to worsen in the second quarter.
Peak oil demand destruction is expected in April and May, with an average decrease of 20mb/d. Even in a scenario where global Covid-19 containment policies are gradually lifted by the end of May, the US Energy Information Administration is estimating a loss of oil demand in 2020 between 5.2mb/d to 9.3mb/d.
To put this number into perspective, in 2009 - the year of the last global recession - oil demand decreased by 0.8mb/d.
Chart 1 (below) shows that almost 58% of global oil demand is derived from fuel for transportation. The impact on demand, and thus the oil market, is significantly worse than in normal recessions because of the widespread implementation of travel restrictions, which has reduced global air traffic by 30%.
Quarantine measures have also caused a significant drop in road traffic, by roughly 40%, leading to a large drop in demand for petrol and diesel.
Record deal to cut production
The imbalance in oil markets was exacerbated in early March, when Russia and Saudi Arabia could not agree on production cuts.
In fact, quite the opposite took place as Saudi Arabia, in retaliation, started a price war by giving rebates on their crude oil exports and announced an increase in production starting in April.
However, the steep fall in oil demand and rapidly rising inventories have now convinced the world's top producers to reverse course.
On Easter Sunday, the members of the Organisation of the Petroleum Exporting Countries (OPEC) and the main non-OPEC oil producing countries (known as OPEC+) agreed to a historic cut in production to contain the oil glut.
Oil production will be cut by 9.7mb/d beginning on 1 May. After that, the group will taper the cuts in July by 2.1mb/d and in January 2021 by another 2.0mb/d.
The remaining 5.6mb/d cut will be in place until the agreement expires in April 2022.
To put the cuts into perspective, chart 2 (below) shows the main oil producers and their level of current production.