by Niki Apostolicas
As global economic growth has grinded to a halt, oil markets have experienced a tumultuous two months. Gas station prices have dipped below two dollars per gallon — their lowest price since 2004 — due to unprecedented price shocks, spikes in production, and a dearth of storage capacity. Briefly, the price of petroleum products became negative for the first time in history, with buyers being paid to take on oil. A combination of oversupply and lack of demand led to an international oil crisis that threatens the existence of oil producers and supply chains. Oil prices faced an initial decline in price levels as a result of COVID-19; however the oil price war between Russia and Saudi Arabia has exacerbated the issue by inflating oil supply.
On March 8, The Organization of the Petroleum Producing Countries (OPEC) hosted its 178th conference to discuss supply cuts as oil markets began to tumble. However, instead of reaching an agreement on supply cuts, the meeting ignited a price war between Russia and Saudi Arabia. Saudi Arabia initiated a price discount of 25% and pledged to produce over 10 million barrels per day (bpd) rather than the standard 9.7 million bpd; Russia responded by also ramping up production. These actions not only affected the parties involved but also impacted other international oil markets, such as the American market, where the West Texas Intermediate saw a 25% single-day decrease. In other words, American producers were collateral damage in the Russian and Saudi price war (some analysts have suggested that the Russian motivation for the price war is to drive the American shale producers out of the market). When international oil prices fall, US oil must also undergo price cuts in order to remain a competitive option. Thus, US oil prices must decrease to remain competitive, resulting in substantially lower profits. This further destabilizes the oil markets which are already struggling to manage the rapid decline in demand. In fact, if prices fall far enough, then American producers would receive less money for each barrel of oil than it cost for them to produce: each sale would constitute a loss. The ultimate effect of lower prices is a decrease in oil drilling, which leads to less production and additional layoffs. With American industries struggling to stay afloat and unemployment rates surging, layoffs in the energy sector are especially painful. Oil and natural gas account for over 7% of the United States’ GDP, therefore, the industries’ collapse would have a disastrous effect on the overall American economy. Ted Cruz and Dan Sullivan, senators from Texas and Alaska respectively, have voiced for the price war to end, as these two oil-rich states have been negatively affected by the supply shocks which have destroyed oil prices. Finally, if American oil companies go bankrupt, then when the pandemic subsides, oil prices could become too high for American consumers, dragging down economic growth like in the 1970s.
Ending the price war and agreeing to supply cuts would be the responsible and sensible action to undergo, particularly in a time where there is little to no demand. However, Saudi Arabia is able to suffer the consequences of the price war because of their sovereign reserves, low fiscal debt, and a low marginal cost per barrel. Meanwhile, Russia would see its currency depreciate in a price war. Additionally, Russian economic growth has been tepid for years, a source of discontent among its citizenry. Thus, Saudi Arabia has more ability to withstand the contractions compared to other nations’ oil industries. President Trump threatened to implement tariffs on international oil to prevent international oil prices from falling too low and becoming more attractive in comparison to American oil. This would help the American oil industry by making American oil prices cheaper than international counterparts as well as increasing local demand. However, it would make the price of gas more expensive for everyday citizens. Nonetheless, tariffs would, in the short-term, protect American companies and employment.
However, tariffs should disappear once oil prices reach a certain price point, because tariffs would harm other parts of the American economy if used in the long-term. In addition, in order for tariffs to be effective, they would need to be placed on all international oil suppliers; if only targeted nations such as Saudi Arabia, Russia, and Iraq were affected by these tariffs, American refineries could import oil from other off-shore nations, which would completely negate the goal of decreasing supply. Moreover, most economists agree that tariffs reduce output and more often than not welfare. Therefore, from the United States’ perspective, it is imperative for Saudi Arabia and Russia to solve their price war quickly enough to protect the American economy.
Luckily, the price war ended soon. Saudi Arabia and Russia, pressured by their lack of storage capacity as a consequence of their increase of oil supply, reached an agreement to cut oil production collectively by 9.7 million bpd, an astronomical tenth of daily oil produced. This historic agreement almost fell through as Mexico refused to cut 500k bpd; however, Trump stepped in and was able to broker a deal in which Mexico and the US would cut 100k and 400k bpd, respectively. Initially, the US had stated they would not cut any oil production, but Trump’s compromise to cut 400k bpd not only saved the deal, but also transformed the role of the US in world oil markets. His ability to broker the deal and convince Russia to sign was a victory for the American oil industry and will save many jobs. This moment will help improve relations with all parties involved, especially Mexico, as the US was able to cease the price war and reach an agreeable solution in which all parties involved were satisfied.
Despite hopes of returning to normalcy following this agreement, the constant low demand for oil continues to be catastrophic. With storage tanks brimming and several oil tankers with maximum capacity anchored on the Southern California coast, the issue of storage is ravaging the oil market to the point where oil prices have become negative. This means that oil fields are paying others to take their oil. While some believe that oil companies should shut off production, this would lead to mass unemployment and a loss in opportunity cost. The only real solution in the medium-term would be to increase consumption, an unlikely scenario as COVID-19 continues to ravage the country. With nowhere to store excess oil, the future of the international and domestic oil industry is grim.
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