Coronavirus has hit oil price: How low will it go? How long will it last?

Even before the World Health Organisation declared the COVID-19 outbreak a pandemic on March 12, crude oil price had collapsed. Then started the guessing game of how long it would last, to what level it would fall, whether the oil market would recover, had the group of Organisation of Petroleum Exporting Countries (OPEC) become powerless, why had Russia refused to cooperate, etc.

In early March, Brent crude fell from $50 a barrel to $34. By the end of March, it was close to $20. Some pundits predict that it may fall even below $10. In some landlocked areas like South Dakota in the US and in Western Canada, it’s already close to $5. This, when only a few months back, experts were predicting that Brent would average around $63 in 2020.

Do we really know where oil prices are heading next week, next month or next year? But we all pretend to know, as I did during the first two oil shocks. This is not to be critical of oil economists. For operations and planning purposes, we need to have a price forecast. But it is impossible to do so to any degree of accuracy in the face of a ‘black swan’ event.

In the first week of March, when OPEC+ (OPEC members plus 10 other countries led by Russia) countries met to agree on a production cut, there was no full appreciation of the potential impact of the demand drop due to coronavirus. Still, OPEC’s technical committee had recommended a cut of 1.5 million barrels per day (mmbd), in addition to the earlier quota reduction of 1.7 mmbd, agreed in 2018.

Ahead of the meeting, there were rumours that Russia would not support the additional production cut. But OPEC members expected Russia to go along in the end. That it did not was a shock to them and a big disappointment to the Saudis especially.

As expected, soon after the oil market learnt about the breakdown in OPEC+ negotiations, crude prices fell by 20% in one day. Even then, there was a glimmer of hope that Russia and the Saudis may yet agree on a production ceiling to firm up oil prices.

When nothing changed, experts started to spin out theories to explain why Russia walked out of the deal despite knowing fully well the game theoretic implication that both the parties lose out when each side tries to maximise their own gains.

Is it that Russia wants to force a reduction in US shale oil production by keeping oil prices low? There is speculation that Russia wants to punish the US for sanctions against its Nordtsream-2 pipeline to supply gas to Germany. Also, through lower oil price, Russia wants to prevent the Saudis from developing their huge gas reserves, which will compete with its own.

In 2014, Saudis attempted a similar strategy to reduce US shale production and failed. It is possible that Russia may succeed, but by paying a heavy price itself. On March 30, President Trump called Vladimir Putin to work together to support higher prices. The only thing they agreed to was to talk again.

At the start of the year, till world oil demand was savaged by coronavirus, it was expected to go up by about 1.3 million barrels per day (mmbd). However, now with several countries in partial or complete lockdown, led first by China, oil demand has collapsed.

In addition, there is a general economic slowdown. Oil demand in March might have fallen by about 10 mmbd. In April, it is likely to fall by at least another 10 mmbd. If the spread of coronavirus is not stopped or at least flattened out by the end of the second quarter, oil demand is unlikely to recover even during the third quarter. There is a good chance it may do so in the fourth quarter.

In the coming months (difficult to estimate for how long), the world may have a surplus of as much as 20 mmbd. As discussed above, demand will drop by 20 mmbd. While the Saudis, the Gulf countries and Russia, who have a marginal cost of around $3 per barrel, had expressed intentions to increase production by three, one and 0.5 mmbd, respectively, oil production in countries with marginal cost higher than $20 will be forced to cut production. Such a reduction could be 4-5 mmbd. More than likely, OPEC+ countries will find it difficult to increase their production in this unexpected environment of a historic demand fall.

When there is a massive surplus which is equal to 60% of OPEC’s production, no OPEC action or any agreement between Trump and Putin can support higher oil prices. At best, it may give some psychological support.

The oil industry is in uncharted territory because of the lockdown. During this time, the industry will find it very difficult to balance supply and demand when everyone is trying to maximize production. Only low-cost producers will succeed.

One possible scenario for market recovery is when coronavirus runs its course, and OPEC+ realizes that they have to get back to the negotiating table and hammer out a production quota to balance the market. If we look back at the history, each time oil prices collapsed, OPEC has succeeded in imposing an enforceable quota.

In 1985, the Saudis precipitated a price drop when they could not shoulder the production cuts, and prices fell by 70%. Again in 1997, when Venezuela over-pumped, the Saudis caused a 50% price drop. The latest such drop was in 2014, when prices dropped by 65%.

The crisis brought about by a black swan event like coronavirus will likely force OPEC+ to come together. If they don’t, oil importing countries like India will be able to enjoy low prices for a considerable time.

(The writer is former governing council member of Manipal Institute of Technology, and an international oil expert.)