Reduced demand for oil as a result of the COVID-19 pandemic and the oversupply caused by the oil price war has put increased pressure on the oil industry. The OPEC+ deal reached on 12 April 2020 is intended to address these pressures by rebalancing the market. Below, we share our insights on the impact of the OPEC+ deal.
Background to the deal
On 12 April OPEC+, comprised of OPEC and its allies, including Russia, agreed the largest deal to cut oil production in history. The deal consists of an agreement to cut oil production by 9.7m bbl/d (almost 10% of global demand before the COVID-19 pandemic) from 1 May until the end of June 2020. The cut in production is set to reduce over time to 7.7m bbl/d for the remainder of 2020, with the cuts further reducing to 5.8m bbl/d from January 2021 to April 2022. Oil producers in the G-20 have also agreed to reduce their output, in part due to the weak oil price.
The cuts to production agreed are double the size of those agreed during the 2008 global financial crisis and the deal is aimed at rebalancing the current over-supply and falling demand.
Oil price drop
Despite the historical significance of the deal achieved and the involvement of the US in brokering the deal, the oil price saw short-lived gains. In the week after the deal was announced, the oil price had reduced to levels seen in the days leading up to the deal. On 20 April 2020, the US oil benchmark West Texas Intermediate fell to its lowest level in history, although this was predominantly due to the expiration of the WTI futures contract for May delivery and not purely a result of the OPEC+ deal. The price of Brent crude also faces pressure and dropped to its lowest level in 18 years (below US$20/bbl) on 21 April 2020.
The dip seen in the oil price in the week following the OPEC+ deal reflects the consensus among analysts that the deal reached is insufficient to rebalance the market. Global consumption of oil is currently down almost 30% and the IEA estimates demand throughout April 2020 will be 29m bbl/d lower than the previous year. Goldman Sachs have suggested that production would need to be cut by an additional 4m bbl/d to begin rebalancing the market.
The reduction in oil price is also in part due to competition for market share. Saudi Arabia discounted its official selling prices to Asia by US$4.20/bbl for its Arab Light crude as it works to protect market share in one of its largest markets. Producers are also offering deep discounts in order to capture demand; any potential oil price rally will face additional obstacles. Competition for market share remains and strategies to protect market share are likely to manifest in different ways in the coming weeks. For example, oil producers may try to secure medium to long-term supply deals with China; as China lifts its lockdown restrictions, its refinery utilisation, oil consumption and resulting demand will increase.
Will the deal last?
There is scepticism the deal will last. In previous deals, various oil-producing countries have failed to comply with the cuts agreed. As the production cuts agreed on 12 April 2020 are larger than any previously agreed cuts, challenges in meeting these cuts will be all the greater. It will not be in the interest of any producer to comply with the commitment to decrease production, particularly when the oil price increases.
Continued cuts to production will not be commercially viable for oil producers where the opportunity to compete for market share arises. However, a rise in oil price will need to be sustained for it to be successful. If prices rise and production increases too quickly (or production is not cut by the rate agreed), the oil price could fall further as greater uncertainty will be created in the market. This would also cause US shale production – which Russia, in particular, wishes to see reduced – to drop off as it would be unable to compete.
Should oil-producing countries comply with the cuts agreed, it is likely that the impact of the OPEC+ deal may be felt later in the year. The supply restrictions may begin to raise the oil price as demand increases, with a rapid bounce back in price dependent on an equally swift increase in demand.
The short-term impact on storage
Reduced demand, oversupply and finite oil storage capacity will continue to impact the market in the short term. Some of the world's largest oil importers are preparing to purchase additional oil with the intention of maximising strategic oil stocks and oil-producing countries have agreed to reduce some of the surface supply by putting it into storage. These measures will assist in rebalancing the market in the short term.
Existing global storage is limited; the production cuts agreed by OPEC+ are unlikely to avoid tank tops being reached. Storage prices for onshore storage in North America and Asia have surged during April 2020 and rates to lease VLCCs have spiked. Despite the increased cost of storage, current estimates are that storage tanks and pipelines will reach capacity by the end of June. Some of the existing global storage is forecast to reach capacity before the OPEC+ deal is implemented on 1 May 2020.
The deal reached by OPEC+ will, however, delay the rate at which oil storage reaches full capacity and buy time for new strategies to rebalance the market be developed. Nevertheless, it is possible the current deal will result in some oil producers having to halt production temporarily.
Should storage reach maximum capacity while supply continues to outstrip demand, the oil price could fall in the short term as producers look to find demand elsewhere. The markets are moving deeper into contango, beyond the 11-year contango highs seen in Q1 of this year, as the agreed reduction in production by OPEC+ remains less than the global reduction in demand. Spot prices are unlikely to rise in the immediate future, causing cashflow issues and ultimately impacting financing arrangements currently in place.
The legal impact
Reserve-based lending arrangements continue to be impacted by the sustained low oil price. Current price decks are coming under pressure; they are now likely to be higher than the spot pricing used in their determination and will also not align with many borrowers' current cashflows. Ability to service existing debt is being impacted as a result and a sustained low oil price will reduce future debt headroom under a borrowing base facility.
Borrowing base amounts (reflecting the value of future net cashflows of the borrower's interest in the borrowing base assets) are generally redetermined twice a year. During these redeterminations, assumptions as to the future oil price are made and are then used to set the price deck. Price decks following redeterminations occurring at this time will face significant reductions; borrowers' cash flows will be hit by the low oil price and many will also struggle to raise additional financing at this time.
Where a borrower's limited cash flow restricts its ability to service debt, lenders may look to accelerate facilities or to drawstop any undrawn amounts under a facility. Given the current situation, questions arise as to whether it is possible to call the material adverse effect ("MAE") event of default often contained in facility agreements.
Typically, an MAE would be defined as a material adverse effect on the borrower's ability to perform its payment obligations under the finance documents or on its financial condition, property, business or operations.
Whilst it is common for facility agreements to contain an event of default upon the occurrence of an MAE, MAE events of default are unlikely to be called due to the serious implications lenders face (such as liability for losses incurred by the borrower) for calling such an event of default where it is found not to have occurred.
The events of default most likely to be relied on to accelerate a loan are non-payment defaults, cross-defaults, defaults relating to insolvency/insolvency proceedings and breaches of financial covenants. Such events of default are more clear-cut than the MAE event of default and as such will be easier for lenders to rely on. Should borrowers risk such defaults, early engagement with the lenders on these issues will be key to preserving relationships.
Where defaults caused by non-payment and non-compliance with financial covenants arise, arrangements to refinance deals are generally more common than acceleration attempts. Efforts to refinance existing deals are to be expected, particularly where it appears as though borrowers will remain at risk of non-compliance with their obligations under existing financing arrangements for an extended period of time. As the oil price is forecast to end the year at approximately US$30/bbl, approximately half the value of forecasts at the beginning of 2020, many existing deals are likely to require refinancing.
The anticipated reaction to the OPEC+ deal
The oil price rise the markets were hoping to see as a result of an OPEC+ deal has not occurred. In the short term, the threat of the price war fuelled by competition for market share has been alleviated. The risks of oversupply, limited oil storage capacity and cash flow concerns are likely to be the key factors influencing the market in the immediate future.
The restrictions on production agreed by OPEC+ could risk being labelled as anti-competitive, although this is unlikely. The involvement of the US, one of OPEC's most vocal opponents, in brokering the OPEC+ deal should not only ease such concern but also highlight the importance of securing such a deal. The impact of any anti-competitive sentiment in this instance will be far outweighed by the global economic impact of a sustained low oil price, particularly were a deal not achieved.
Whilst the consensus is that the measures agreed by OPEC+ are not sufficient, the deal should provide a measure of stability and go some way toward preventing the oil price falling further in the short term. Forecasts for oil prices for the second half of this year have risen by approximately US$5/bbl. The deal will support the bottom end of the market and it has removed some of the uncertainty the market faced; this should engender confidence. As the market gains momentum, different types of investment opportunities will come to light in the medium to long term, which may encourage a more diverse range of deal structures.
The OPEC+ deal also shows that Russia and Saudi Arabia are not in a race to the bottom, whereby market share is consistently prioritised over the oil price and its associated economic impact. The agreement reached on 12 April 2020 may pave the way for future deals.
OPEC+ are scheduled to meet again on 10 June 2020. The current deal is expected to be reviewed at that time.
The contents of this publication are for reference purposes only and may not be current as at the date of accessing this publication. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2020