“Things fall apart; the Centre cannot hold, mere anarchy has been loosed on the world.”
I started my last article on oil with this quote from W B Yeats. I do so again because I think it is apposite. The centre of the oil market has collapsed and for those engaged in the oil business, it must seem as if anarchy has indeed been loosed upon them.
Earlier this week, people woke up to the headline that the price of the benchmark US crude WTI had entered negative territory. For the non-cognoscenti, this was an extraordinary and incomprehensible piece of information. Why would producers “pay” consumers? Why did they not simply leave the stuff in the ground? For the cognoscenti, the information was also dramatic. But the questions were different. Did this herald an irreversible structural change in the oil market? What might be the geopolitical implications? What specifically does this mean for India?
The collapse in the price of WTI reflected a technical peculiarity of futures trading. Paper traders would normally have had two options. To let their contract expire and take physical delivery or to pass on the contract to someone else. But this was not a normal month. The US was running out of crude oil storage capacity and traders knew they could not “risk” taking delivery. There was no physical space to hold the product. So their only option was to sell the contract. This was not easy as everyone faced the same physical constraint. So, on the last day before the contracts expired, the traders in desperation “paid” to offload their risk. There was no physical transaction. The dramatis personae were paper speculators, not oil producers. The current future price is back in positive territory.
That said, the headline did bring into sharp relief a structural reality. The world (and not just the US) was fast running out of storage capacity. This was because oil production was way in excess of demand. The latter had crashed by almost 30 million barrels a day or mbd (the equivalent of OPEC’s entire production) because of the COVID-induced lockdown of transportation and industry. The price of the other crude benchmarks had also dropped but not the same extent — the North Sea Brent fell, for instance, to $15/bbl, a level not seen since 1999. The reason was that unlike the WTI, which is traded in the US and therefore dependent on US inland storage capacity, the other crudes have access to seaborne storage (oil tankers). This latter capacity is, however, fast filling up and the price of these crudes may also hit historic lows.
So, where are we headed? One clear pointer. Oil prices will be volatile downwards until demand picks up and/or supply is further cut.
Demand will depend on the curve of post-COVID economic recovery. Which letter of the alphabet will it follow? V, U, W, L or I? The last “I” ( that is, continuing decline ) is, of course, the doomsday scenario. Optimists are looking at V or perhaps U. The epidemiologists might suggest W: An initial recovery, reversed by a second wave of infection followed by a strong and enduring upturn as and when a vaccine is developed.
Supply will rest on the outcome of further discussions amongst OPEC, Russia and, ironically, the US. OPEC and Russia had earlier this month agreed to cut production by 10 mbd. But clearly, this is not enough and further cutbacks have to be agreed on. The US, too, will have to reduce production. Its companies are currently producing approximately two mbd more than is required by the refineries. The government cannot mandate such a cutback but the market may force it. At current prices, many companies are barely able to meet their production costs.
Whatever the scenario for economic recovery or supply constraints, there is a slim likelihood of crude oil prices reaching the average price levels of 2019 ($64) over the next 12 months or so. More likely, they will be volatile downwards with $50 as the ceiling and with no floor.
This “low for longer” price outlook raises two issues for our policy-makers. One, what are the supply risks? And two, what can they do to maximally leverage the advantages of low prices?
One could provide many answers to these two questions but for lack of space, let me make just two points.
First, every oil producer (with no exception) will face a budgetary crisis. Some, like Saudi Arabia, the UAE and Kuwait will finance their social and economic commitments by cutting costs, increasing debt and drawing down on their sovereign reserves. Others like Iran, Iraq, Nigeria and Venezuela, who have no such cushion and whose credit ratings are junk, will confront deepening political and social crises. India should build into its economic plans the possibility that its traditional oil supply routes could get disrupted. And that its diaspora, whose remittances are of significance, could face disproportionate hardship as these economies retrench.
Second, on the day prices hit negative territory, I wondered whether the trading experts in our oil PSUs had the flexibility to even contemplate “buying” the WTI futures contract for June, taking delivery, shipping it to India and storing it someplace. I also wondered whether they had the authority to lock in low prices through forward contracts. These were, of course, academic reflections. I know there is a shortage of storage capacity in India and a mismatch between the quality of WTI and the requirements of our refineries. Nevertheless, I had these thoughts because I am clear we cannot leverage the current market conditions of low and volatile oil prices to our national advantage unless we empower the traders and leave them unencumbered from bureaucratic control. And, most importantly, protect them from the three Cs ( CVC, CBI and CAG) in case their trade goes awry.
I am not suggesting we ask our traders to emulate Wall Street. I am merely suggesting this oil market crisis could be made to work to our advantage. We must not waste this opportunity.
The writer is chairman and senior fellow, Brookings India
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