What exactly has triggered the energy crisis?
As we’ve mentioned in our previous article about the crisis, a bunch of unfortunate occurrences have happened lately.
If you are familiar with the case, then you will remember that on March 9, oil prices fell by more than 30%. The bad news did not end there. All the world’s major exchanges on this day showed the worst results since the global crisis of 2008. The New York Stock Exchange even suspended trading for 15 minutes. Both European and Asian exchanges have panicked as well. So, let’s find out the causes and consequences of the oil and stock market shocks.
Of course, it can’t be just one reason that has caused this mess. First, some experts claim the decrease in oil prices would have taken place without a virus pandemic, and a warm winter is one of the reasons for that.
Second, I cannot but mention one of the major causes of the global crash – a global pandemic. A lot of enterprises are closing their branches and headquarters, and this applies not only to China, where the situation, by the way, has just about stabilised. Passenger traffic is sharply reduced. A big number of countries have announced that they are going to implement a shutdown (quarantine), so most people can’t enter or exit a country without a special purpose/permission (i.e. embassy employees, doctors, etc). Such a self-isolation concept means a drop in revenue for airlines, travel services, and the entertainment industry. Vehicles and public transport are less used during the quarantine. Therefore, a lot of experts are expecting a significant decrease in oil demand.
Knowing all this, most analysts expected a reduction in oil prices by 20-25% from the rate of $60 per barrel, to around $45 – $50 for a barrel. However, a third factor unexpectedly came into play. Namely, it happened when OPEC decided to support the oil price and proposed a reduction in production (assuming that it would be possible to keep it above $50 per barrel), Russia (its reduction share was 3%) reacted with an unexpected hard rejection.
Thus, on March 6, the OPEC countries were unable to agree and, consequently, extend the agreement on reducing oil production. On the eve of the negotiations, OPEC and Russia discussed a reduction in oil production amid the global prices decrease due to an epidemic of the Wuhan coronavirus.
As we’ve already mentioned above, due to the spread of COVID-19 and the related investor concerns about the declining demand for gasoline, diesel and jet fuel, world oil prices have plummeted. The decline in production advocated by Saudi Arabia and several other countries was supposed to help maintain a market balance in the face of weak demand. The Russian Federation did not agree with such a decision.
As a result, during negotiations in Vienna, Moscow refused to apply restrictions. What’s interesting, without the participation of Russia, the OPEC countries did not see any sense in keeping limiting their oil production. The Kremlin’s decision was unexpected for other members of the organization. The current deal will cease to be effective on April 1, after which all restrictions on oil production will be lifted.
Numbers and calculations
What’s more, Russia announced that it’s not just declined a three percent reduction, but also going to exit the previous agreement, which means the country is going to maximize production. However, this statement sounds strange, because Russia’s maximum is rather close to the figure it actually produces. Unlike Saudi Arabia, Russian oil companies have no way to significantly increase production. At the same time, Russia spoke openly about the reasons for this action, and according to Russian officials, it was not about earning money. Some of them said it was about driving the American oil shale industry out of the market, but we’ll get back to this later.
If Russia reduced production by 3%, and the price fell by 10%, this would mean the country would have incurred insignificant losses of about 4% of today’s revenue, which is not very painful for Russia. In addition, the alliance could declare a production decline, but each of its members could cheat a little (which is almost normal practice, a kind of an “unwritten rule”). At this point, Russia wouldn’t feel the effect of an agreement at all.
As a result of the demarche, oil prices dropped to $35-38 per barrel, “taking away” from Russia $10-15 from each barrel, which, in fact, means at least 25% of revenue. Even if Russia would apply the maximum performance mode, it can increase production compared to the OPEC quota by 10%, reducing losses up to 17.5% compared with what it would have in case of cutting a deal with OPEC. The Russian market reacted immediately. Namely, the ruble (which tens of millions of Russians use as major savings currency) fell by 10%, the RTS index, in which over a million Russian citizens invested in the last year, lost more than 30% compared to the last local maximum and is currently trading at 45% of the absolute maximum that it reached in 2007.
Russia vs the US
The idea to outplay the US is not fresh. However, it looks even weirder when it comes to the oil shale industry (we promised we’d revert to this issue). Firstly, the shale industry differs from the conventional one. It’s easy to reduce or stop production, and then resume it, if we are talking about oil shale production. The oil shale well is emptying rather quickly, so you have to drill more and more if your production level is to be constant/stable. Therefore, if you do not want to mine anymore, you can just close the well, and do not drill a new one. The number of wells is falling as production is declining. Americans can easily leave this market, as well as enter it again.
Secondly, the US tight oil production is hedged, especially when it comes to price fluctuations, and supply contracts are usually annual (with fixed prices). Therefore, the effect will not be instantaneous, and most likely a real reduction in US production will occur at a time when the consequences of the pandemic will not be so tangible, and oil demand will recover. This, in its turn, will smooth out the impact of dropped prices and allow Americans to remain in the market. On the one hand, there are some companies in the oil shale industry that used the on-lending option, and most probably, such companies would go bankrupt. But companies’ bankruptcy doesn’t seem like the biggest problem for America. On the other hand, even if a change of ownership of oil fields occurs, in general, this will not have any effect on the industry. On the contrary, the market would get rid of “bad credit history” companies, and the industry will work even more efficiently.
And thirdly, the entire American oil and gas sector mainly works for the domestic market and is not directly dependent on world prices. Moreover, this sector is about 7% of GDP. By the way, the Russian oil and gas sector is about 15% of GDP. At this point, the US is much better protected from oil price drops than Russia.