Welcome to the era of the new oil shock

Oil prices have continued to tank over the past week bringing the Brent crude dollar price per barrel down to the mid to low twenties, levels not seen in almost two decades. Amid a flurry of excitement – prompted by a Trump tweet on Thursday – there was a sudden, sharp rise in prices, but the pressure looks likely to be downward.

Two factors have driven prices to historic lows. The first is of course the giant economic toll exacted by the coronavirus pandemic. With mass quarantines shuttering large sections of the global economy and vastly reducing domestic and international travel global demand for oil has dropped sharply. The International Energy Agency has predicted that oil demand may drop by as much as 20% next month as the global economy slows.

Yet even as demand has dropped off production has risen as Saudi Arabia and Russia battle it out for market share. This dispute also has its origin in the global economic slowdown caused by the pandemic. Facing declining oil prices Saudi Arabia, which needs oil selling at $80 a barrel to balance its budget, proposed a sharp reduction in oil production at the OPEC+ meeting in March to try and shore up the price. Russia, which only needs oil at $42 a barrel to balance its budget, refused to cooperate.

The Saudi response was then to drastically increase oil production, ramping up from 9.7 million to 12 million barrels a day, the increased production apparently supposed to make up for the decline in price. Russia has responded in kind, though can likely only increase production by around 300,000 barrels a day, creating a battle for market share. However, the predictable result has been to crater prices further.

Donald Trump has been urging talks between the Saudis and the Russians to settle the dispute, and oil prices rose today as he hinted a deal was close.

But on Thursday the Kremlin categorically denied that President Vladimir Putin had been in talks with Saudi Arabia. It seems that Trump was either indulging his penchant for wishful thinking, or showing off about being in on secret negotiations which would hardly be conducive to their success. In any case this touted deal, like so many of Trump’s deals, seems to have evaporated.

Adding to the downward pressure on oil prices, thanks to the sharp reduction in demand and boom in production, the world is fast running out of space to store this glut of oil. Experts are predicting that global storage capacity may be completely full by the end of this month. The situation is so extreme that producers may actually find themselves paying people to take the oil they are unable to store off their hands.

Falling prices have already forced sharp cutbacks in production at oil fields which can’t turn a profit at these rock bottom prices – though not enough to counter-balance the deluge of oil coming out of Russia and Saudi. Some small producers in America are already facing bankruptcy if things continue as they are.

Even more worrying are the potential effects of these low prices on economies heavily reliant on oil revenue. Ecuador, Iraq, Nigeria, and Mexico are all facing sovereign debt crises if the current state of affairs persists with potentially devastating results given the persistent instability and widespread poverty that these countries already face. National oil companies are also going to encounter severe challenges at a time when many are loaded with debt adding to the woes of the countries that guarantee them.

Global markets could well take a beating as result as huge amounts of debt tied to oil companies, or propped up by them, becomes difficult to service. High returns on oil over the past two decades has also meant that it has been a standard part of many portfolios meaning a sharp decline in profitability is going to have a ripple effect across the financial sector.

As for the industry itself the big question is what happens post-coronavirus when demand picks up again.

Some are predicting that the fabled point of peak oil consumption may be arriving sooner than we think, or may have arrived already. In this scenario economies reopen and oil consumption does pick up again but never recovers to the same high. This could be due to a prolonged recession or depression following the pandemic.

Alternatively, even if the global economy recovers relatively fast, oil consumption could decline as short haul and long haul travel is reduced with aviation companies struggling to recover, production being reshored to reduce supply chain vulnerability, and working from home and online conferencing becoming far more common.

This could conceivably happen regardless of whether oil prices recover or not. Persistently low prices would undermine returns, and in turn investment in new exploration which has already been dropping sharply over the past few years.

Alternatively, oil prices could shoot back up regaining or surpassing previous highs as demand recovers. Some wells which are no longer profitable to operate in the current climate are being closed and more may follow – reopening them would be expensive and take time.

Shale oil extraction, which is currently taking a battering due to its high costs and the industry’s heavy debt burden, could make a quick comeback as it can resume production faster.

Or the transition to green energy could accelerate as solar and wind cement their recently established status as cheap alternatives.

Others are speculating the current price slump could actually increase oil consumption over the next few years. Governments keen to fuel quick economic recoveries post-pandemic will be tempted to binge on large quantities of cheap oil and the willingness of companies/consumers to pay more for green credentials shrinks in the face of economic hardship. A delayed transition to a green economy would also mean oil consumption continuing to increase even as prices begin to rise.

Still, even in a best-case scenario recovery the oil industry that emerges from this crisis will deeply changed. An increasing number of companies will be driven out of business so long as lower prices and reduced demand persist. Those that survive may well find that a large portion of their market share has been devoured by Russia and Saudi, and investors are reluctant to pump money back in fearing oil may now be a more volatile asset – particularly if Russia and Saudi struggle to resolve their differences.