Delving Deeper into Oil – US oil prices fall negative

Monday 20th April 2020

The price war between Russia and Saudi Arabia is one of the most historic moments in the oil industry. It is often forgotten how well-integrated society and the economy is until something like this happens. To understand the impact on people’s everyday actions, let us categorise our lives into a few categories: house, car, health, children, occupation, and food.

If any one of these factors are shunted, the others are also hit - like a domino chain. This analogy can be coupled with current affairs as the fallout of the coronavirus pandemic is damaging both the energy and transportation industries. As more and more countries are beginning to enforce stringent quarantine measures in efforts to contain the virus (such as lockdowns and social distancing) and more people become infected with Covid-19, fear crowds people’s minds. As a result, people are less likely to travel, they may lose income due to unemployment, and house prices may fall.

This effect can be seen in recent news events. In the housing sector, Zoopla warns that UK house prices could plunge dramatically as the coronavirus outbreak causes demand to dry up. Meanwhile, in the automotive industry, Wood Mackenzie believes Electric Vehicle (EV) sales could crash by 43% as supply outweighs demand. With less people travelling, the supply of oil is greater than demand and so the falling oil prices result in a major shift in the global stock market. This has had a domino effect toppling several currency pairs in the foreign exchange market. However, the domino effect doesn’t end here. With escalating fear around Covid-19, more people bulk buy essentials and so demand outweighs supply – causing an increase in the price of certain foods and household goods. As some foods become more expensive, and less people work or have their full incomes, living standards begin to take a turn for the worse.

From all this, one can begin to see how well-integrated the everyday actions are with the state of the wider economy.

Price War

In terms of oil, the price war between Russia and Saudi Arabia began on 8th March 2020, facilitating a 65% quarterly fall in oil price. The price war was triggered by disagreements between the Organization of the Petroleum Exporting Countries (OPEC) and Russia over proposed oil production cuts in the midst of the 2019–20 coronavirus pandemic. Russia walked out of this agreement and immediately the 30% drop in oil at the start of the year became larger. Following this, US oil prices fell by 34%, crude oil fell by 26%, and shortly after, Brent oil fell by 24%. When oil prices are this low, more money is spent by oil-producing companies in extracting oil than they receive selling it – meaning they will struggle to break-even. A direct consequence of this is a hit to gross domestic product (GDP). For example, as a consequence of falling oil prices and a range of other pressures stemming from the pandemic, the UK’s Chief Economist expects UK GDP to fall 5.3% in 2020. However, he extrapolates a 5.1% growth in UK GDP for 2021.

OPEC and OPEC+

OPEC is the Organization of the Petroleum Exporting Countries, which is an intergovernmental organisation that seeks to regulate the supply of oil from its members. In consists of 13 countries: Algeria, Angola, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, the Republic of the Congo, Saudi Arabia, the United Arab Emirates and Venezuela. OPEC+ was formed in 2016 and consists of OPEC countries and their allies such as Russia. The aim was to make the global crude oil market more well integrated and thus to offer more control over the industry. The landmark agreement held by OPEC+ in March 2020 proved to be a demonstration of the collaboration between OPEC+ countries.

Landmark agreement

In efforts to minimise this drop in oil prices, OPEC+ met for an agreement to cut oil production. The agreement was for crude oil producers to reduce their overall production by 9.7 million barrels per day for an initial two-month period. Some Gulf countries promised to voluntarily remove another 2 million barrels in addition to the above cut agreed by OPEC+. The participating countries also agreed to adjust oil production over time, regularly decreasing oil production cuts until April 2022. It seems then, that with an agreement finalised, the price war is finally put to an end. However, as of 20th April 2020, oil initially fell to below $14 a barrel. In the biggest intra-day drop since 1982, prices then fell to $11 a barrel, followed by $4 a barrel. The Financial Times later reported that US oil prices had become negative, with the West Texas Intermediate (WTI) price benchmark falling below -$40 a barrel. Such unprecedented developments prove that an agreement does not necessarily guarantee an upward market trend.

This brings us back to supply and demand and the integration of society and the economy. Due to the Covid-19 pandemic, world demand has collapsed twice as much as the agreed cuts by countries and this does not seem likely to change in the near future. Whilst some countries are beginning to pass their respective pandemic peaks, the economic recovery promises to be a slow one.

Is there still hope for oil investors? The next few months in the oil markets will tell.