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Oil price wars in a time of COVID-19

Mar 11,2020 - Last updated at Mar 11,2020

A combination of supply and demand shocks have sent oil prices plunging and financial markets tumbling. If the decline in oil prices persists, it will erode the fragile macroeconomic and social stability of countries, especially in the Middle East and North Africa that have been hit by the novel coronavirus, COVID-19.

 

History of OPEC decisions

 

In November 2014, the Organisation of Petroleum Exporting Countries (OPEC) decided to maintain output despite a perceived global glut of oil. The result was a steep decline in price. Two years later, in November 2016, OPEC took a different route and committed to a six-month, 1.2 million barrel-a-day (mbd) reduction in crude oil output. The result was a small price increase and some price stability. But the respite was to be temporary, because the price increase stimulated other oil production that could come on line quickly, primarily from shale in the United State.

On March 5, OPEC proposed a 1.5mbd production cut for the second quarter of 2020, of which 1mbd would come from OPEC countries and 0.5mbd from non-OPEC but aligned producers, most prominently Russia. The following day, Russia rejected the proposal, prompting Saudi Arabia, the world’s largest oil exporter, to boost production by 300,000 barrels-per-day to 10mbd, Saudi Arabia, which has a production capacity of about 12mbd, also announced unprecedented discounts of almost 20 per cent in key markets. The result was a more than 30 per cent plunge in prices, to as low as $31.1 per barrel on March 8. The upward pointing futures curve suggests the market still expects oil prices to slowly recover, and reach $50 per barrel by the end of 2024. That said, as we assess the stance of the different protagonists in this month’s oil war and the response of shale production, it seems clear the futures curve will likely shift.

 

Covid-19 and uncertainty 

about oil demand

 

Since the discovery of the new virus and infections in China at the beginning of 2020, oil prices have declined about $20 a barrel, in anticipation of reduced oil demand as widespread COVID-19 infections depressed output.

Indeed, as authorities in China shuttered production facilities as part of their efforts to contain the spread of the virus, oil demand from China dropped significantly. The Oil Market Report from the International Energy Agency (IEA) underscores the importance of China’s role in oil consumption. China accounts for 14 per cent of global oil demand and for more than 75 per cent of global growth in demand.

The newly released report forecasts that in 2020 global oil demand growth will fall for the first time since 2009. The 0.09mbd demand decline in March is 1.1mbd lower than the forecast made in February, which already was well below the forecast made in January. The IEA expects global demand for oil to fall by 435,000 barrels per day year-on-year in the first quarter of 2020 by 365,000 barrels per day for the year as a whole, the worst demand performance since 2011.

Indeed, because of China’s increasingly important role in the global economy, any setbacks to its economy are expected to significantly hurt the rest of the world.  The global fear and uncertainty regarding the spread of virus is likely to hurt investment decisions in China and in other countries, further weighing on demand prospects and lowering oil prices.

The collapse in oil prices roiled financial markets already nervous about the spread of the novel coronavirus. Equities in United States and the rest of world lost about 7 per cent. Shares in US shale companies were hardest hit, with some shale stocks losing 30 to 50 per cent of their value. But a decline in oil stocks overall signal the market perception of a persistent drop and that the oil price war will affect higher-cost production the most. Moreover, US government bond yield moved to historical lows, while the VIX, a measure of market volatility, hit its highest levels since the financial crisis more than a decade ago. These moves suggest that investors have heightened fear of a recession and have intensified a search for safety.

 

Economic and social effects

 

As the world struggles with the fear of recession, the Middle East and North Africa (MENA) could be the hardest hit by what is arguably a perfect storm: The coronavirus spreads to the region and oil prices collapse. This in a region already raked by social discontent and massive street protests.

As of March 6, Iran had reported over 4,500 infections and at least 43 deaths. The rapid rise in infections there is likely to disrupt the country’s production and trade. As the virus spread, Iranian authorities closed schools and cancelled art and film events, and neighbouring countries closed their land borders with Iran. Other MENA countries have also reported infections.

The ability to contain the virus depends on the strength of the public health systems of the MENA countries. WHO ranks most MENA countries relatively high among the world’s 191 health systems, with a few exceptions, such as Yemen, which 120, and Djibouti, which was ranked 157. But some MENA countries might face difficulties containing the virus. For example, wars in Syria and Yemen will almost certainly impede the proper functioning of the health systems in both countries.

As a rule, lower prices are good for oil-importing countries and bad for oil exporters. A simple way to get a sense of the size of the real income effect is to multiply the difference between production and consumption (net oil export) as a share of GDP by the percentage point increase in the oil price. For instance, based on hypothetical assumption that oil prices were to stay 33 per cent below the 2019 level, Kuwait, where net oil exports account for 43 per cent of GDP, would experience a decline in real income of about 22 per cent of GDP. For the same increase in price, Morocco would experience an increase in real income equivalent to 3 per cent of GDP.

But in MENA it is likely that lower oil prices will directly hurt oil exporters, whose income will decline, and indirectly importers, who will see reduced foreign direct investments, remittances and grants from the exporters. Some countries, such as those in the Gulf Cooperation Council, still have buffers and should use them. Other oil-exporting countries, such as Algeria and Iran, are exhausting their buffers and will have to rely on flexible exchange rates to manage the current situation and conduct much-needed reforms in private-sector development and broader economic transformation. Among oil net importers such as Lebanon, Jordan and Egypt, a recession will contribute to already high levels of public debt.

The battle against the spread of the novel coronavirus and its economic consequences will be complicated by empty government coffers. The region will need much international support to help it navigate a very rough patch.

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