Oil has been dubbed as the most valuable commodity with some even referring it as black gold. Until recently no one would have believed that the price of oil could have reached below USD 20 let alone into negative. Last week, in an unprecedented historical event, the West Texas Intermediate (WTI) i.e. USA oil benchmark traded at negative USD 40. This means that the oil producers and suppliers ended up paying buyers to get rid of the oil. Even though, the WTI has since rallied back as its June contracts are currently trading at around USD 17, it has left us to ponder over the situation.
How we got here?
The oil market predominantly operates on the future contracts whereby a buyer and seller agrees to sell / purchase the oil at a certain price on a specific date. These contract are either materialized i.e. oil is delivered or sold to another buyer on an agreed price. The crash was primarily observed in the May contracts which were expiring soon. Foreseeing insignificant demand, the traders with long position, instead of taking delivery, started to sell their contracts. While more and more traders put their contracts on sale, amid no buyers, the price reached zero and later on into negative zone.
In broader terms this shock is due to a simple phenomenon called demand and supply gap. We used to study the law of demand and supply in our college economic classes, this is a prime example of the demand and supply at price determination. On one side the demand for oil has slumped while on the other side oil producers are reluctant to curtail the production. The oil price shock has been witnessed in the wake of the coronavirus outbreak and consequent lockdowns, travel restrictions, shutting down factories, and observing social distancing measures to stop the spread of the virus. According to an estimation made by International Energy Agency (IEA) the global oil demand may fall 9.3 mb/d in 2020 YoY basis while the demand in April 2020 lowering by 29 mb/d as compare to April 2019.
On the other hand the global oil supply remains the same throughout March and April causing surplus in the market as the world powers couldn’t agree on a reducing oil production earlier. USA – the largest oil producer, kept pumping oil into the market amid lack of demand. To reduce the market imbalances, the OPEC+ bloc – led by Russia and Saudi Arabia – have agreed to cut production by almost 10 mb/d. Likewise, the USA and Canada have also announced to reduce their output in the upcoming months. However, slashing production could result in loss of thousands of jobs that are tied to producing crude either directly or indirectly.
Despite historical cuts in oil production it is expected that the market inequality will continue and the oil prices will remain under pressure for quite some time.
What is expected ahead?
As the outlook for global economic activity remains uncertain, forecasting oil prices and the level of global oil consumption in the coming months is a challenging task. According to the IEA report, the demand for oil is expected to be 23.1 mb/d below, for the second quarter of 2020. The recovery in the third and fourth quarters will be gradual while in December demand will still be down 2.7 mb/d as compared to last year.
Moreover, the oil prices are expected to increase gradually in 2020 as the economic inactivity will continue to be a factor.
What should be done?
The current oil crisis warrants coordinated efforts from the world leaders. Since the oil surplus is expected to remain in the market, the issue can be managed by taking the following measures:
- The oil producers should further cut the oil prices as the current production level is still higher than the expected demand until June 2020.
- Countries having strategic oil reserves storage capabilities should offer their facilities to the oil producers or they may buy at a lower price and increase their country`s oil reserve stock. The US president Mr. Donald Trump has already hinted on increasing their Strategic Petroleum Reserves (SPR) which has a capacity of 713.5 million barrels. Where possible the capacity of strategic oil reserves may be increased to dump the excess oil.
Together with reduction in production, replenishment of strategic oil reserves, and countries relaxing lockdown / introducing smart lockdowns, the oil market may start to stabilize by the end of this year.
Could Pakistan benefit from this crisis?
The global oil crises has been a blessing in disguise for oil importing countries such as Pakistan with huge trade deficit. The WTI crash had a ripple effect on other major oil benchmarks including Brent and OPEC basket. Pakistan is buyer of OPEC oil basket which is currently trading at around USD 15; therefore, it would benefit from the WTI crash indirectly. As the oil prices are expected to remain low in 2020, Pakistan`s current account deficit will shrink in the upcoming months. From the end consumer perspective, lower oil prices would result in low production cost and thus low inflation.
