On March 9, equity, energy, bond and currency markets all were launched into turmoil as the oil price collapsed. Hit by both a demand and supply shock, oil has fallen nearly 50 percent this year. Although oil producers are likely to be hit hard by this latest development, the longer-term effects of the oil price collapse are not all bad. The worry for individual governments trying to counteract any negative effects is that there may be little they can do for now.
The impetus for the March 9 sell-off in oil was the collapse in talks between Russia and OPEC on further cuts to oil production. This was the fastest collapse in price since the 1991 Gulf War – Brent crude settled around $34 a barrel, down 24 percent – but it comes just five years after another price collapse in 2014-15, when prices fell to $30 from $115 in 18 months.
Back then, OPEC and Russia eventually came to an agreement to cut output by 1.8 million barrels per day. That amounted to approximately 2 percent of global supply. This time, as Riyadh pushed for even more aggressive cuts of up to 3.5 percent of global supply, Moscow balked.
With no agreement between OPEC and non-OPEC states, Saudi Arabia did the same thing as in 2014 – it launched a price war by boosting production and discounting its product to Asian and European economies to grab market share.
The Saudis are able to undertake this aggressive push because production costs are low in the kingdom. The cost of producing and transporting a barrel of oil in Saudi Arabia (and other Gulf states) is less than $10. In Russia, it is $30. In the US, it is closer to $50.
So, by boosting supply and forcing prices lower, Riyadh is putting pressure on those higher-cost producers, particularly the US, where production has increased to 12.8 million barrels per day from 5.5 million bpd in 2009, overtaking Saudi and Russia to become the world’s largest producer. The last time Saudi pursued this strategy in 2014-15, one million barrels of US production were removed as it became unprofitable to operate some wells.
But the policy is not without pain: The fiscal breakeven price for Saudi Arabia is approximately $83 a barrel. This means that every dollar the price of oil falls below this level, Riyadh must borrow money to fund its spending. In 2012, Saudi ran a fiscal surplus of above 13 percent of GDP; after the oil price crash, this flipped to a deficit of 15 percent of GDP in 2015. Effectively, Riyadh had to borrow $100 billion that year to balance its books.
This is true for all states reliant on oil as a key source of government revenue, particularly in the Middle East. The fiscal breakeven price throughout the Gulf is far above current oil prices: in the UAE it is $70, in Oman $87, in Bahrain $92 and in Iran $195. All of these countries will be forced to borrow more money, cut spending or draw down on reserves (which, in the case of Saudi and the UAE run into hundreds of billions of dollars). For states with stressed debt positions already – Bahrain’s debt to GDP ratio is already approaching 100 percent, for example – the probability of a systemic crisis is heightened.
For other oil-producing states, the pain may be less severe, but still substantial. In Russia, the fiscal breakeven price is $42 a barrel, but its currency is likely to suffer (it was down more than 8 percent on Monday) and could create its own crisis momentum.
In the US, a depressed oil price for a substantial period of time is likely to pressure its own oil production. But the economy as a whole is much less reliant on the industry and declines in the price of gasoline provide an effective stimulus to consumer spending, the main driver in the US economy. A report by the Brookings Institution in 2016 suggested that the oil price collapse in 2014/15 had a close to net zero effect on the economy as greater consumer power was balanced by declining capital expenditure in the oil industry.
For oil-consuming nations, the oil price slump could prove a very timely fillip. China is now the world’s second-largest oil consumer and largest oil importer. In 2019, China imported a record 10.1 million bpd. If the price of oil remains where it currently is, this would suggest roughly a $30 a barrel price discount this year, effectively saving China more than $100 billion. This boon obviously could not come at a better time for the Chinese economy, still reeling from an effective shutdown in February caused by the coronavirus.
Other major oil importers, such as India, which last year spent $100 billion on oil imports, could save approximately 1.5 percent of GDP on a 50 percent price cut, while coronavirus-hit economies such as Italy would also see imports decline by about $15 billion or 0.75 percent of GDP.
The oil price slump will therefore have a range of effects: harmful for oil-dependent economies in the Middle East, potentially catastrophic for debt-laden economies, relatively neutral for the US on a macro level and positive for oil importers in Asia and Europe.
The shale industry in the US has been among the worst hit, while lower oil prices will also mean far less capital expenditure, tightening the oil project pipeline potentially for decades to come.
The oil price is caught between the Scylla of a demand shock – the largest drop in demand since the Great Recession – and the Charybdis of a supply shock. Governments had already begun to react to the worsening economic environment with monetary stimulus in the shape of interest-rate cuts. These are now likely to be matched by targeted fiscal stimuli to support oil and affected industries and bolster oil-dependent economies.
But even while these stimuli may deal with the symptoms, the systemic causes of the oil price collapse are beyond government control. Until demand increases as the virus ebbs in China and elsewhere or supply is restricted through a reduction in US shale output or a new OPEC deal, there is likely to be further pain for producers through 2020.
Christian Le Miere is the founder of Arcipel, a strategic advisory firm based in London and The Hague. Previously he was a senior advisor to an entity in Abu Dhabi and a senior fellow at the International Institute for Strategic Studies in London. @c_lemiere