The second quarter was bad for oil companies. Industry giants like Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) reported losses in the billions of dollars. Even Saudi Aramco (SE:2222), the most profitable oil company in the world, reported a 73% decline in profit compared to the same quarter last year.
All of this was expected since Saudi Arabia’s overproduction policy in April sent oil supply soaring while lowering oil prices, all while the economic lockdowns in response to the coronavirus pandemic decimated oil demand.
Given these developments, there are two important questions to consider:
- How much can oil prices recover now that Saudi Arabia has returned to normal production levels and countries are reopening?
- How much better can oil companies perform in the second half of 2020?
The Problem With Saudi Aramco's Outlook
Saudi Aramco offered a very positive view for the second half of the year in its earnings call on Monday. According to CEO Amin Nasser, the energy giant is banking on growing oil demand in Asia to help it recover profits in H2. On the face of it, this seems like a good strategy. Asia, in particular China, saw its greatest drop in oil demand at the beginning of 2020 and was already starting to recover in March and April, when Europe and North America’s oil demand hit its lowest point.
70-75% of Saudi Aramco’s crude oil sales head to Asia, so the company is set up to benefit more from rising Asian oil demand. However, there is a serious problem with this outlook.
Oil is a global commodity, and Asian demand is not the most important factor in setting the global oil price. Even with demand from China growing over the past few months, oil prices have remained remarkably stable, moving only slightly within the $40-$45 range, over the past two and half months.
The United States is the largest oil consumer and the largest economic power in the world, so economic and oil demand news from the U.S. tend to play a larger role in setting global oil prices than information about Chinese demand or Chinese economic growth does. If the market price doesn’t rise, Aramco will have difficulty raising its OSPs.
In addition, Aramco is hamstrung by Saudi Arabia’s commitment to OPEC+ production cuts. Aramco’s cost of production is so inexpensive that even when the price of oil is down, Aramco can lift its profit by selling more oil to Asia. China, in particular, has been keen to purchase more oil for storage when the price is low. However, because Saudi Arabia is committed to keeping its oil production at 9 million bpd, Aramco can’t increase its sales to China unless it draws down its own inventories.
Oil Demand Challenges
Oil demand outlook in the United States and Europe remains mixed with some indications that it's improving, but the growth is modest. Refinery utilization in the United States improved last week to 80% (though this number can be attributed partially to a change in the set of refineries included) and crude oil inventories declined by 4.5 million barrels. However, total motor gasoline inventories increased by 700,000 barrels last week. Crude oil, gasoline and diesel inventories all remain well above average for this time of year.
In Europe, the UK reported that it has fallen into the deepest recession of any global economy. Even with governments no longer stifling economic activity, the recession caused by these policies will continue to negatively impact oil demand and likely keep prices depressed despite activity in Asia.
Bottom Line
Reining in production was not enough to raise prices above the $40-$45 range. Barring a supply catastrophe, we will need exceptional demand news to see a significant jump in prices. However, the major consumers of oil are just starting to come to grips with their economic conditions, and they still have yet to overcome fears of the virus, so it is hard to imagine demand growth in the immediate future.
Oil companies will do better in H2, because March and April were shockingly bad months. However, without higher prices and without the demand to sell markedly more oil, investors should not expect great news.