The coronavirus pandemic is not just a health emergency – it may just be the cause of a global meltdown. The pandemic could cost the global economy between $5.8trillion and $8.8trillion, according to the Asian Development Bank (ADB). It has exposed some deep-rooted systemic issues which remained in obscurity in the past because they served us passably well.
In these dark times, there are very few things which haven’t lost their sheen. The energy sector is presumably one of those few sectors which can remain insulated against any long-term effects. It may suffer short term shocks but it cannot be really suppressed for long. After all, industry - of any kind, will still need energy. Among the various sources of energy generation, historically, crude oil has led the march towards a global market for energy. A year on year comparison reveals that the worldwide export value, in absolute terms, increased by 5.5% in 2019 over the 2018 figures. It remains one of the most important commodities in the world – perhaps even a touchstone of economic recovery. While enjoying an uncontested monopoly, it has often served as the fuel to the globalisation engine. Considering the roller coaster price movements that oil prices have been stuck in, a closer look is warranted into whether crude oil has lost some of its sheen.
Contracting industrial outputs all over the world, restrictions on social gatherings, and doubts regarding China’s ability to steer oil prices with a record-high crude purchase have all cast a pall over sentiments in the oil market. The United States is one of the largest importers of oil in the world, nipping at China’s heels. Considering that the US has been staring down the barrel of burgeoning debt obligations, it should come as no surprise that the current political scenario has further curtailed its demand for crude oil. In July, the International Monetary Fund projected that the curtailment of production may reduce the income of oil exporters by as much as $270 billion.
As the pandemic reduces global demand, some energy pundits predict that there will be a crude oil glut. The supply of oil exceeds the demand, especially, when global economic activity remains suspended for a while. In the month of April, US crude oil prices entered the negative territory for the first time in history. The excessive supply of oil means oil exporting countries are facing unprecedented situations where they are running out of storage space for the unsold barrels. This means that suppliers of oil are willing to pay any prospective buyers to take the oil off their hands. It is forecasted that the disruption in the daily demand for oil will cause a loop in the demand and supply, as many countries have been unable to utilise their oil reserves, owing to the restrictive measures required for the Covid-19 pandemic. Oil markets, quite understandably, are perturbed; the prices of crude oil have been falling for a while - even before the coronavirus crisis hit.
Figure 1: Oil prices have been falling for a while, even before 2020.
Experts claim that globally, the demand for oil has been on a downward slide, while the supply either remained constant or increased. Perhaps the demand of oil has been falling due to the rising preference of renewable sources of energy. Renewable sources of energy are poised to be the fastest growing sources of energy, encroaching on the still dominant traditional sources such as natural gas, oil and coal. The time of energy transition may be here – perhaps we have passed the peak of oil demand.
Such a statement, which seemed absurd even six months back, may not sound as preposterous today. A recent report from the chief economist of British Petroleum posits the same query – and the results are not entirely unexpected. The demand for crude oil has already been quite sluggish and if the economic recovery follows a L or a U shape, meaning a longer interval till pre-Covid levels of economic activity, then the pinnacle of oil consumption may well lie in the past.
Figure 2: An L-shaped recovery may spell disaster for the oil market.
Of course, this doesn’t mean that oil exporters will sit idle and watch their capital erode by inaction. The Organization of Petroleum Exporting Countries (OPEC), which controls nearly 80% of the proven world oil reserves, aims to pre-emptively manage the market and arrest the trend of falling prices. OPEC remains a huge influencer of oil prices, due to a lack of any feasible alternatives in the energy sector and enjoys the benefits of economies of scale in oil barrel production. In 2020, when the oil prices collapsed, OPEC and its allies agreed to reduce the production of oil. However, as previously mentioned, the existing oil reserves are yet to be consumed, which means the production cuts are still to take effect on prices.
This is interesting, because, the Saudi Arabian Oil Company, rules the roost as one of the most valuable companies to be traded publicly. Taking the state-owned Aramco public is part of the plan that was envisioned by Prince Mohammed Bin Salman that aims to improve the employment opportunities through fortifying the private sector in non-oil sectors. This ambitious plan is, of course, a rather pragmatic approach to the global push for cleaner sources of energy. Aramco has been the engine of economic growth for Saudi Arabia and caused quite a stir in markets when it went public in December, briefly valued at $2 trillion, a first for any company. However, 2019 figures revealed that it is not insulated against the falling prices, as the profits had fallen significantly from 2018. This hasn’t stopped Aramco from being bullish about the future though – falling crude prices or not, the officials at the company expect that the OPEC’s cutting down on production will be helpful and expect that the demand for oil will pick up. This optimism, although well-meaning, seems rather naïve; oil prices continue to plunge.
Federal Reserve officials and OPEC plus members reignited concerns of a lengthy market slump, expecting the resurgence of coronavirus cases to push back recovery to 2021. Trump’s continuing rhetoric against China does not help matters either – it will lead to a downturn of trade between two of the world’s major economies in a time when the world can ill afford such stand-offs. Stability is the need of the hour.
In spite of such gloomy forecasts, some organisations such as Barclays and the Bank of America are betting on a spike of oil demand as stockpiles of oil are diminishing and the production of oil has already been truncated. The chances of simultaneously implemented lockdowns worldwide are rather low now and a stronger than expected demand recovery may be a rallying point for oil prices. And if Aramco’s actions are to be taken as any kind of indicator, oil markets may be clawing their way back to profitability. Aramco has raised the prices of its crude oil for the Asian market, expecting the winter season to shore up the oil demand for heating purposes. That may give the oil businesses some reason to cheer. The interested parties however are suggested to tread with caution. Research shows that demand for gas lighting peaked when electricity was in its infancy, and as we all know, history can, and quite often repeat itself. Investing in oil for a long-term horizon may be a mistake. Growing awareness about climate change and worldwide push for cleaner/renewable sources of energy will perhaps lead to systemic behavioural changes. The more perceptive investors, should, thus, look for greener pastures. The oil market is like an ageing building – it’s still beautiful, but its glory days are behind it.
The author is an Assistant Professor of Finance at St. Xavier’s College (Autonomous), Kolkata.
The opinion/s expressed in the article are that of the author's and do not necessarily represent or reflect the policy or position of this magazine.