Crude in free fall as Saudi Arabia decides to cut oil prices

  • Mar 09, 2020 GMT
  • Team Kalkine
Crude in free fall as Saudi Arabia decides to cut oil prices

Crude oil prices today lost more than 30 per cent of its value, to be trading at around US$33 per barrel at the time of writing this report. Last week, crude oil prices had breached US$ 50.00 per barrel mark on account of the downward revision in the anticipated global demand of the commodity accentuated by the concerns of the coronavirus spreading outside of China. However, the free fall in crude prices today is on account of the feud between OPEC and non-member country Russia which has refused to participate in a production cut option proposed by OPEC.  The organization had called a meeting of member countries in Vienna to consider ways to deal with the crisis. Saudi Arabia, the largest member of the organization, retaliated to the Russian move and slashed its official crude oil selling prices, leading to a full-blown price war.

Russia and the OPEC had a three-year agreement whereby both sides had agreed to support production cut in order to check the slide in prices. But the recent talks between OPEC countries to cut production on account of Coronavirus scare was not supported by Russia. The collapse of the agreement led to panic selling in the Asian bourses amidst fears of a re-run of a 2014 type scenario when a price war between the two sides had led to a crash in oil prices by two-thirds. The Saudi Arabian decision to cut prices works against the objectives of OPEC of which it is a prominent member. The organization has been trying to protect the interests of its member countries in attempting to provide support to the global crude prices in the midst of the current threat to the world economy by cutting production and not prices. This price war initiated by Saudi Arabia is having a disastrous effect on crude prices. Brent crude futures fell by  $14.25 per barrel, down to $31.02 a barrel shedding nearly 31.5 per cent while the U.S. West Texas Intermediate also lost almost 27.4 per cent in prices to $30 a barrel falling nearly $11.28 per barrel, which is the single largest drop in percentage terms since the 1991 gulf war crisis, in both cases.

The fear of the spread of the coronavirus through human vectors has severely impacted the movement of people across the world. Even with the very few that have travelled, the virus has been able to spread to more than thirty countries now.  Less travel means less oil usage and consequently less demand for crude oil. Other than transportation, manufacturing and mining activities also use significant amounts of fuel oils which in the current scenario is also experiencing a severe downturn. Parallels are being drawn off the present coronavirus induced economic crisis to the 2008 era financial crisis which had pulled the world economy into a recession. This time around, the Reserve Bank of Australia and Federal Reserve of the United States of America have announced massive rate cuts in anticipation of the worst that might happen should the current crisis prolong beyond a few months. China, which in recent years had emerged as the world's largest manufacturing destination, has many parts of the country in virtual lockdown, with imports into and exports out of the country limited only to the bare essentials. The World Health Organisation and other national and international organizations of eminence working in the field of public health are taking massive steps to stop this dreadful virus from spreading to more geographies. The World Bank in the last week has announced the allocation of nearly $12 billion to help infected countries fight the infection, along with significant amounts being spent by countries like the United States and China which have also employed massive resources to contain the spread and cure those who are already infected.

The impact of this price war will be severe for other small oil-producing countries in the middle east and elsewhere whose economies are heavily dependent on oil revenues. In the United States of America, the production of crude has increased significantly on account of its expanding exploitation of oil sands resources. The worlds second-largest economy and the largest importer of oil is in a fragile economic shape leading to a significant reduction in demand for crude oil. Thus, the double whammy of falling demand and falling prices would only add to the current world economic crisis.

The current state of the world economy is weak on account of the coronavirus scare and yet is unique and different from a general slowdown in many respects. Unlike a general economic downturn, this slowdown has been induced by structural faults that have developed rather than general recessionary conditions. The scare of the epidemic has severely limited the movement of people and goods. So even if there is demand in some parts of the globe, supplies are not able to meet them because of logistical bottlenecks and not because of lack of supply. This will eventually lead to an oversupply of stocks and subsequently into production cuts. Thus, measures, like reducing interest rates or fall in crude oil prices, would have a limited impact in increasing the pace of global trade. This, however, could backfire and create more structural problems for the world economy than solving any. Not only will this price war lead to a fall in the estimated GDP of many economies which heavily trade in this commodity, but medium and small oil and gas companies around the world would face severe pressure on their revenues and profitability, which could push them to the brink of bankruptcy.

To say that the world economy is heading towards a recession would be a little far-fetched at this stage but the negative factors that are leading towards that have not been so potent in the past few years. Prolonged weakness in crude oil prices would lead to a significant shortage in production as many small and medium companies will go out of business. Fall in interest rates without a real economic growth to back it up will lead to a weakness in the currency, and a fall in the general price levels will result in deflationary economic conditions.

The coronavirus epidemic is not likely to abate for at least the next few months. Travel and transportation industries, the main drivers of demand for the crude oil industry, are expected to continue to reel under losses for some more time after the epidemic has abated. The accumulated losses of the Oil & Gas sector until that time would be a major cause of concern for the world economy, which could lead to severe capacity constraints. The current price war situation in the realm of crude oil is a consequence of the coronavirus epidemic. Should the status on this front persist for long, more such problems might crop up, which could take a heavy toll on the world economy. The only solution out of this rapidly deteriorating state of the world economy is to contain the spread of the virus as soon as possible. This may lead to limiting the losses that the world economy has already sustained, plus, it could also shorten the recovery period.

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