Since the dawn of the oil era, prices have been subject to a certain extent of volatility. But the depth of change over the last few weeks is unprecedented. At the start of 2020, one barrel of oil was sold for over $60, but in mid-April the price plummeted to about $20. On April 20, the price of West Texas Intermediary (WTI), the U.S. benchmark for light crude, fell well into negative territory for the first time in history. Sellers have had to pay customers to take unwanted oil: an unimaginable and untenable ask of the industry. This episode highlights the industry’s disarray and raises several important questions: What is spurring this extreme volatility? How will the United States respond as the world’s largest producer (19% of total) and largest consumer (20% of total)? How will this crisis impact the six Gulf Cooperation Council (GCC) states?
Like any commodity, the price of oil reflects the balance between supply and demand. The drastic changes in daily social and economic activities around the world in response to the COVID-19 pandemic have pushed the global oil market out of balance. On the supply side, in March the members of the Organization of Petroleum Exporting Countries (OPEC) and other major producers, mainly Russia, were unable to extend a previous agreement signed to cut production. This failure permitted a lift of all restrictions and major producers have thus started competing for the market share. In early April, the global market was flooded with a substantial surplus. This excessive production prompted world leaders to renegotiate a new oil deal under which OPEC members and other producers agreed to cut production by 9.7 million barrels a day, the deepest reduction in history, to begin in May. On April 10, the agreement was further endorsed by the world’s largest economies through the G20. The United States, Canada, Norway, Mexico, and Brazil indicated that they would reduce their production too. However, some industry analysts claim this recent agreement as “too little, too late.”
Plans for unprecedented supply cuts by OPEC+ have, so far, failed to offset the tumble in oil demand. The efforts are considered as insufficient to immediately rebalance the market given the scale of the drop in demand. Daily global consumption is projected to fall by approximately 30 million barrels in April, three times the cuts pledged by OPEC and other producers. This significant collapse in consumption is likely to persist for some time in light of the ongoing global health crisis. Refineries are unwilling to turn oil into gasoline, diesel, and other products because so few people are commuting or taking airplane flights and international trade has slowed sharply. The American Petroleum Institute estimates that global oil production is still about 100 million barrels a day but demand has fallen to 70 million barrels.
This combination of excessive production and substantial reduction in utilization has created a new challenge concerning global storage facilities for the multitude of oil the industry continues to pump out. The world has an estimated storage capacity of 6.8 billion barrels, nearly 60% of which is filled. In a nutshell, there is an enormous global surplus met with little demand, and possible storage venues are dwindling. Until the coronavirus pandemic eases and economic growth returns, downward price pressure will continue.
The United States’ Response
In the last two decades, cheap oil has become a double-edged sword. American presidents have traditionally pushed for low oil prices to fuel the world’s largest consumer. The shale revolution of the early 2000s has significantly altered the energy sector, creating a thriving local industry and transforming the nation into the world’s top producer as well. Unlike other cheap oil episodes, the current low prices do not necessarily benefit American consumers since most economic activities have been temporarily suspended due to the coronavirus. Rather, the collapse of oil prices is hurting the oil industry in Texas, Oklahoma, North Dakota, and the rest of the country. In this context, President Trump was personally involved in the negotiation between OPEC and other producers to cut production.
The global oil glut and very low prices have created an environment where U.S. oil companies cannot survive. The American oil industry needs much a higher price than $20 per barrel in order to compete and make profit. In April, President Trump has considered at least two options to mitigate the situation – store oil in the Strategic Petroleum Reserve (SPR) and/or impose taxes on imported oil from Saudi Arabia and probably from other countries. Each option presents its own problems. The main U.S. storage hub in Cushing, Oklahoma is expected to be full within weeks. The president has reiterated plans to store excess oil in the SPR, which has about 635 million barrels of oil and is equipped to store 75 million barrels more. Unfortunately, for technical reasons, it would take several months to store this extra oil.
The second option under consideration is to impose tariffs on imported oil in order to coerce foreign producers to cut production and protect U.S. companies. Foreign oil is still being imported because U.S. refineries are better equipped to handle foreign crude than they are the light variety produced at home.
It is also important to point out that unlike many other countries, the U.S. government cannot commit to a government-mandated production cut. Such commitment can only be made by private oil companies. In recent weeks, these companies have drastically cut back capital spending and have begun to close some of their production wells.
The Impact on GCC States
Despite serious efforts to reduce their dependency on oil revenues, the GCC states continue to be heavily dependent on exporting oil and natural gas for economic success. This dependency makes them vulnerable to the fluctuation in prices. It is important to distinguish between the short- and long-term impact of low oil prices. Accurate figures on their financial losses are not yet available, but the International Monetary Fund (IMF) projects that their growth will contract by 2.7% in 2020 and the current account will shift from a surplus of 5.6% of gross domestic product (GDP) in 2019 to a deficit of 3.1% of GDP in 2020. In the coming few years, governments will be forced to cut spending, raise borrowing, and delay or halt government investments.
Despite this gloomy short-term economic outlook, the sky is not falling. The medium to long term looks bright. The IMF projects that economic growth will accelerate in 2021. The real GDP rate (adjusted for inflation) in all six states will grow: Bahrain (3.0%), Kuwait (3.4%), Oman (3.0%), Qatar (5.0%), Saudi Arabia (2.9%) and the UAE (3.3%). Long time ago, the GCC states (and other countries) created sovereign wealth funds/oil funds (SWF) such as the Abu Dhabi Investment Authority (1976), Kuwait Investment Authority (1953), Qatar Investment Authority (2005) and the Saudi Public Investment Fund (1971). As in previous financial crises, the GCC states are likely to utilize some of their financial reserves in these SWFs to stimulate their economies. The SWFs provide the GCC states with large financial cushions and serve as buffers against short-term economic downturns.
The Way Forward
Deeper production cuts seem inevitable to stop the collapse of oil prices in the coming few months. Once COVID-19 is contained and economic activities around the world resume, market forces are likely to bring back the balance between supply and demand. Typically, low prices encourage higher consumption and lower investment. This combination leads to a rise in demand and fall in supply, and the price will reflect this new balance. However, this optimistic long-term projection should not slow the GCC states’ immediate efforts to diversify their economies away from oil and gas revenues. For a number of years, many analysts have argued that the peak of oil era has passed with the so-called “energy transition.” Gulf states should thus double down on their investment in human capital and prioritize striving for knowledge-based economies.
Dr. Gawdat Bahgat is a professor at the Near East South Asia Center for Strategic Studies at the National Defense University. He is the author of 11 books on the Middle East. The opinions expressed in this piece are the author’s alone and do not represent the views of the U.S. government or the policies of the Department of Defense.
The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of Gulf International Forum.