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Oil Market meltdown

  • IASbaba
  • March 11, 2020
  • 0
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Economy & International Affairs

Topic: General Studies 2:

  • Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment. 

  • Effect of policies and politics of developed and developing countries on India’s interests

Oil Market meltdown

Context: Saudi Arabia cut oil prices and declared its intention to increase output well beyond what the oil market can absorb currently.

As a result, Oil prices fell (almost one-third) by the most in one day since the 1991 Gulf War. The price of U.S. crude fell as much as 34% to $27.34 a barrel.

The oil market is now set to witness the rare conjunction of a demand and a supply shock which is bad news for prices. 

Why Are Oil Prices Falling?

  • First came the coronavirus outbreak, which reduced travel and transport, sharply reducing demand for fuel.
  • China, a major importer, has cut its imports by a third from Saudi Arabia, its biggest supplier
  • The international Brent benchmark had fallen from $69 at the start of the year to around $50 during Feb Last Week

Why sudden fall in prices within a day?

  • There was meeting between OPEC and non-member countries in first week of March. On the agenda was a production cut of 1.5 million barrels a day, or about 1.5% of global production
  • The idea was to keep prices from declining further as demand was expected to fall in 2020
  • Saudi Arabia, the world’s No. 2 oil producer, wanted No. 3 Russia and other nonmembers to take 500,000 barrels per day of the cuts. 
  • Since 2016, the Saudis and the Russians have worked together on production issues.
  • But this time Russia refused to join new cuts, or even to extend previous production cuts that were due to expire at the end of March, 2020.
  • And the Saudis hit back, by announcing that they were going to ramp up production and slash prices for Asian customers.

What Is Saudi Arabia’s Goal?

  • First, protecting market share. Both Saudi Arabia and Russia have seen U.S. producers (No 1 producer of Oil in world) take a chunk of their market, and falling prices help keep customers on board.
  • Second, Saudi Arabia may hope that the pain of low prices will force a Russian rethink.

What Is Russia’s Goal?

  • Russia may have a longer-term target: the U.S. oil industry.
  • There is a view that Russia’s action can damage the financial health of U.S. shale-oil producers (highly leveraged & running on low margins) and that by doing this they can take a lot of U.S. capacity offline and thereby remove U.S. producers as a source of competition.
  • Russia may also have decided to hit back at the U.S. industry after Washington placed sanctions on Russian state oil company Rosneft for marketing Venezuela’s oil.

What does this Mean for US Producers?

  • According to the Federal Reserve Bank of Dallas, $50 per barrel is the price at which it becomes profitable to drill a new well in the U.S.
  • The current low prices could constrain activity in the American shale oil industry. 
  • A downturn in oil prices in 2014-2016 hurt companies in places like the Permian Basin in west Texas and eastern New Mexico. 
  • In Texas, the number of active rigs fell from 553 in October 2018 to 398 in January 2020. Around the same time, the oil industry in Texas shed about 14,000 jobs
  • U.S. shale oil industry could find itself into unviable financial position and the industry can come to a halt due to the lack of further investment in the industry

Impact on the world

  • Price fall is a bad news for the big oil companies and the smaller shale oil players who are highly leveraged
  • A collapse of these shale oil producers may set off defaults in the bond markets
  • With stock and bond markets already in turmoil, the price war now set off in oil is only going to make the markets more volatile and murkier. 

Impact on India

  • A fall in prices is good news for major consumers such as India, where nearly 85% of India’s oil needs are met by import
  • This will reduce the oil import bill at a time when merchandise exports are likely to suffer due to the freeze in the developed economies
  • This will keep the current account deficit balanced.
  • The fall in fuel prices will also drag down headline inflation giving the RBI elbow room to cut rates. 
  • But the oil price fall may be bad news for the Centre’s disinvestment programme as the sale of Bharat Petroleum Corporation Limited (BPCL) could run into difficulties.
  • Big oil companies, which are widely expected to bid for BPCL, may either shy away from it or their bids may be much lower than expected as the company’s valuation may drop
  • In such an eventuality, it is quite possible that the government may step in to grab a slice of the windfall from falling prices, through higher excise duties to compensate for the loss from disinvestment proceeds.

Connecting the dots

  • Impact of fall in oil prices on Europe
  • Strategic Oil Reserves in India

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