The price of oil has plummeted recently. This memo explains the drivers of the recent price development, i.e. the combination of both supply and demand shocks. It also briefly discusses the impact and outlook.
Oil price (STI) 1990-2020
Source: BMO GAM, Bloomberg, BCOM, 20 March 2020.
The oil price (“West Texas Intermediate (WTI)”) has plummeted since the start of 2020. From USD 61, the price fell to a low of USD 20.4 on 18 March (-66%) and has since risen slightly to USD 24.5 (20 March). This is still around 60% lower compared with the start of the year. There are several forces driving this development.
To begin with, worldwide oil supply was already too high at the beginning of 2020, despite OPEC’s efforts to restrict oil supplies in recent years. These restrictions were an attempt to maintain viable prices, while at the same time preventing oil prices from peaking.
This despite OPEC’s efforts in recent years to restrict oil supplies in order to try to maintain viable prices, while at the same time preventing oil prices from peaking.
In the next phase, the coronavirus started to spread around the world. Since the notification of the first infections at the end of December 2019 in China, the virus has spread explosively. An official pandemic has been declared and the virus has now reached over 170 countries, resulting in 292,142 measured infections and 12,784 deaths. (source: WHO, 22 March 2020).
Corona infections worldwide
Number of infected countries
Source: BMO GAM, WHO, 20 March.
China has responded with a “lock down” of affected provinces. This hit the Chinese economy considerably, and with it the oil market. The demand for oil in China is very significant and represents about 20% of the global demand. Furthermore, economies in other countries were affected through various channels: production, supply, consumption, import and export, and tourism.
While China seems to have succeeded in controlling the epidemic, in Europe (the current epicentre of the pandemic), and increasingly in the US, social and economic movements are coming to a standstill and national borders are being closed.
The cessation of economic activity, the implosion of tourism and air traffic, as well as less road traffic has drastically reduced the demand for energy and oil.
What accelerated the fall in prices, on top of the drop in demand, is the fact that oil is more difficult to store than other commodities such as metals and agricultural products. Available storage capacity is limited, which explains why oil prices have been hit so hard by the crisis.
The figure below shows the price development of the various sub-indices of the Bloomberg Commodities Index (BCOM). The energy index has clearly been hit hardest. Incidentally, all five sub-indices went down in March, albeit to varying degrees. Precious metals were hit the least, as they also perform a refuge function in times of crisis.
Bloomberg Commodities: spot price development sub-indices
Source: BMO GAM, Bloomberg, BCOM, 20 March 2020.
Adding insult upon injury for the oil price, OPEC+ fell apart at the beginning of March after Russia and Saudi Arabia decided it was time to flood the world with oil in order to change the production landscape; namely to strike a blow against the American shale oil producers.
Over the past 10 years, American oil producers have become the number one oil producer, even above Saudi Arabia. This year they have also become a net exporter of oil, which represents a historic and strategic turnaround for the US. From a strategic point of view, there is no better time for Russia and Saudi Arabia to start a price war when demand and prices are already extremely weak. This is when the enemy is most vulnerable. Initially, Saudi Arabia pushed for a reduction in production by OPEC+. When Russia did not go along, Saudi Arabia decided to engage Russia in the price combat and to increase production as well.
That was the reason for the oil price opening more than 20% lower on Monday 9 March (after a failed OPEC+ consultation). From a historical perspective, this was the worst day for oil since 1991 (first Iraq war).
Top-5 crude oil producers: daily production
Source: BMO GAM, Bloomberg, US Department of Energy (DOE), October 2019
The oil price implosion has an enormous negative impact on entities that benefit from a high oil price. The American oil industry is particularly vulnerable to low oil prices. The shale gas sector generally operates with a lot of leverage, and bankruptcies in this sector can trigger a chain reaction of banks and lenders that get into trouble. That is why President Trump declared on March 19 that the US would intervene in the price war with Russia and Saudi Arabia at the right time. The result was that after the low of USD 20.3 on March 18, the price rose by no less than USD 5 (+24%) to USD 25.2 in one day.
It will come as no surprise that as a result of the coronavirus and the price war between Russia and Saudi Arabia, the energy sector lost more than any other sector in this year’s S&P 500 index , with a performance of -59%.
Sectors S&P 500: share price development since the start of 2020 until 20 March (%)
Source: BMO GAM, Bloomberg, S&P 500, 20 March 2020.
Oil-producing and oil-exporting countries are negatively affected by this development. The energy sector in high-cost countries such as Canada will suffer particularly badly from this price implication. Production will also be curtailed in the US, perhaps more aggressively than in Canada, as US shale operations tend to be smaller companies that are more price elastic than Canada’s multi-billion-dollar oil sands. Nevertheless, the impact will be significant for business and industry stakeholders. But also Russia, the OPEC countries and Saudi Arabia (low cost, but with a high dependency on oil revenues) will be negatively affected by the low prices. It is to be expected that investments in the energy sector worldwide will be frozen and workers made redundant.
Oil production top 10 countries: absolute and per capita
Source: BMO GAM, US Energy Information Agency 2019, VN 2017
For the net importers of heavy oil such as Europe, Japan, China and India, lower oil prices are a clear positive result. It will help them cope with the negative economic impact of the coronavirus. Meanwhile, oil-producing emerging countries such as Brazil and Mexico are likely to face increasing pressure on their local economies and currencies, as external income from oil exports remains weak.
In general, lower oil prices would benefit consumers, but as many people stay at home as a result of the measures taken against the coronavirus, these benefits are less important now.
Top 10 countries: crude oil imports 2018 (USD billion)
Source: BMO GAM, http://www.worldstopexports.com/crude-oil-imports-by-country/
At current price levels, most of the world’s oil production is unprofitable, and so such low prices can’t last forever.
However, because the endgame for Russia and Saudi Arabia is to change the global production landscape to their advantage and because they have the capacity to absorb the pain for a few months, the low oil prices may persist for some time.
Another factor will be how the coronavirus pandemic develops and the policy of governments in response to it. It is becoming increasingly clear that there may not be a rapid V-shaped recovery and that a longer period of social restriction will be needed. This is to spread the number of new infections over time in order to prevent a peak overload of hospitals.
Although the example of China indicates that after about a month and a half the number of active infections peaked, followed by a decrease, social life there has still not completely returned to normal. And in Western countries a different approach was chosen (often involuntarily, because it was too late for a complete “containment” strategy).
Estimates indicate that “flattening the curve” is not about weeks, not even months, but may take years. Another reason why this may take longer than previously expected is the huge increase in the number of newly infected countries in recent weeks. These are still at the beginning of their epidemic.
Oil prices are hard to predict. However although the present oil prices are (too) low, these levels may persist for some time, from both the supply and demand side.
The oil futures market does, however, price a higher futures price in the longer term (see futures curve below for STI). This may be good news for oil producers in due course. However, such a futures curve does imply a negative roll yield for commodity investors, as the prices of longer-term futures are higher than those of short-term futures.
WTI Futures curve (up to maturities 130 months)
Source: BMO GAM, Bloomberg, NYM, 20 March 2020.