Oil prices last week plunged into negative territory for the first time in history, briefly halting at -$37.63 USD[i] before sharply retreating. In a recession of many firsts, the global demand for oil has decreased [ii], with buyers clearing their oil holdings as places to hold the liquid run low. All of this too is occurring in the middle of an oil price war. This volatility is certainly a reminder of 2020’s harshness to date.
The two biggest oil producers are also in a feud. OPEC+ and Russia seem to be in a war of attrition; both parties are crippling with oil’s collapse, needed for government revenue and economic activity.
Russia is further struggling with its coronavirus outbreak. Already, projections for large deficits and a damaged federal budget (over 40% of revenue derives from oil and gas) are exposing its vulnerability [iii]. But why did the market start paying people to take its oil, and is there an end in sight to this price war?
The drastic drop in oil prices will be a double-edged sword upon daily life. For motorists, petrol prices have been the cheapest in the last 20 years. Struggling businesses will benefit as costs decrease, as one of their major expenses are being elevated. Fuel is an input to many industries, from agriculture to logistics; Cheap fuel makes it easier to make deliveries and run machinery. Furthermore, similar to how a drop in interest rate allows more money in mortgage-payers wallets and thereby boosts spending, lower petrol price leaves people with more disposable income, which gives a stimulatory boost to the economy.
However, whilst petrol prices sound great to the consumer, a stark reality awaits. Oil prices have an intricate relationship with inflation. For example, if the price of oil rises, then it will cost more to make plastic, and a plastics company will then pass on some or all of this cost to the consumer, which raises prices and thus creates inflation. Naturally, with oil prices at record lows, sets in a new reality of ‘negative inflation’. The RBA confirmed that it expects June quarter inflation results to be sufficiently below zero to create negative annual inflation. Deflation can negatively affect consumer confidence and spur a decline in consumer spending habits. Consequently, deflation can be devastating in the long term, as it creates higher levels of unemployment and results in consumer debt defaults. The last time the world experienced continued deflation was during the Great Depression. To what extent the oil drop will worsen the current economic situation, has yet to be seen.
Much like the ‘crude awakening’ of the 2008 GFC, the reverberations of a drastic decrease in crude oil demand and prices will have lasting effects on Australian and global financial markets. However, as our current trajectory out of COVID-19 remains unknown and unclear, so too will be the full impact of this negative oil pricing on these markets.
Following Russia’s obstinate refusal of Saudi Arabia’s proposal to lower oil production in the midst of the Covid-19 pandemic, an all out economic war is taking place.
Almost all of Russia and Saudi Arabia’s economic and political clout is contingent upon the production and exportation of oil. And as they are both countries that are relatively undiversified in terms of economic exports (90% and 59% of Saudia Arabia and Russia, respectively, is determined by oil revenues) [iv], their nations’ success hangs in the balance as both countries reach a stalemate. While Saudia Arabia enjoys the lowest associated cost of production it still needs an US$80-per-barrel price to balance its budget – Russia needs a price of US$60 a barrel. Compounded by the severe imposition to financial markets that Covid-19 is already creating for Russia and Saudi Arabia, the financial impact of the price war could plunge their economies into a deficit that they may not fully recover from.
Other countries, viz Australia, who are not directly engaging in the price war can look towards this negative oil pricing favourably.
However, in order for Australia to take full advantage of the situation it would require significant investment in storage and logistics infrastructure as well as the initial economic cost of purchasing the oil. This has to be assessed against the opportunity costs associated with that level of investment. This will be particularly relevant to the tertiary education, tourism and air transport sectors – given that they are already under enormous financial stress. Furthermore, this opportunity cost must take into account the negative perception that investment in crude oil will make in our already floundering climate change stance – as crude oil is an input that heavily contributes to greenhouse gas emissions.
Therefore, Australia has a choice: take advantage of the low oil prices and make the financial outlay required to store the excess oil, or hold off and spend that money on the economic and financial response to Covid-19.
Globally, the crash in oil prices has not been nearly as severe as that of the domestic US market. The Brent crude oil price, regarded as the international barometer for oil prices[v], reached a 20 year low of 16.02 USD[vi]. This pales in comparison to the negative figures seen in the West Texas Intermediate crude oil price, the benchmark for American oil. The reason for the difference in price change lies in the capacity to store the respective oil grades. Brent crude oil is produced in the North Sea and storage is not restricted nearly as much as for WTI. The latter has the constraint of necessitating storage close to the source, on Texan land.
The ongoing coronavirus pandemic has certainly affected every person on Earth in some way. The lack of demand leading to historic crude prices has been one of many outcomes. From a global perspective, and indeed an Australian perspective, these notable prices are likely to only severely affect the domestic American market, given that they pertain to the unique quirks of the Texan oil market.
The Australian Government has seized this opportunity, opting to purchase 94m AUD of WTI crude[iv], with Minister for Energy Angus Taylor noting that the Government would “take advantage” of the extraordinarily low American oil prices. In the face of coronavirus uncertainty, now does seem to be an appropriate time to ensure Australia’s oil reserve levels are adequate. Problematically, the fuel reserves are to be stored under the supervision of the American Government indefinitely. Now is the time to ensure that Australian purchased crude is promptly available for Australian businesses.
Only tangentially related, Australian oil refinery branches Caltex, Viva, BP and Exxon have all suffered marked hits to their profit margins[xi], but this is a result of the ongoing pandemic rather than the specific American negative prices.
For Australia, the latest turmoil regarding WTI crude is an opportunity fraught with ambiguity. For the USA, the impact may continue into the long-term with investors deciding to put their money into safer commodities. For the world, this oil crash is a reminder of the difficulties that coronavirus has brought forth. That even after the virus has been vanquished structural issues regarding energy viability and responsiveness to biological disasters may persist.
The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ, our Partners and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.
My name is Nigel Pereira, Economics and Japanese is my passion, and I love the process of actualizing our thoughts onto the screen in front of us.
I'm a third-year Commerce student studying Economics and Finance. I am interested in the intersection between international politics and macroeconomic policy, and societal ramifications of such intersections. I plan to study a Masters of Engineering next year.
This author has not left any details
Charlie is a Bachelor of Commerce student majoring in Economics and Finance. He is interested in macroeconomics, politics and current affairs.