Written by guest author: Bryton Johnson
As the COVID-19 pandemic stretches further into its life span, governments, investors and economists prepare to face a war on two fronts. The unprecedented impact of COVID-19 has had on the way humanity interacts with each other has created disastrous implications for the world of global commerce. The starkest reflection of this new global pandemonium is the catastrophic nosedive in oil prices. This historic fall has shocked investors and governments as the traditional views of oil as a safe ‘blue-chip” investment have been shattered in a matter of days. See below for a graph of both crude and refined oil prices accurate to Monday, April 27th.
This steep decline has forced economists to shift their efforts towards unpacking the implication of this oil price crash, and subsequently predicting what this could mean for governments and investors in the short and long term. So far economists have determined that this oil price crash is an amalgamation of a variety of economic events. These include:
-Decreased demand for energy due to the closure of large-scale business in attempts to contain the coronavirus
– An unwillingness of the primary oil producers to reduce oil supply to the levels required to see a price rebound
– The extraordinary political tactics of Saudi Arabia and Russia to win their price war against one another; and
– A negative futures pricing on crude oil
To better understand how this will impact every aspect of the economy and our daily lives, I will unpack the critical economic events bellow.
To understand the decrease in demand, we must establish that oil is a crucial secondary product in the creation of things we use each day. Oil is immensely versatile, contributing to the plastics your food comes in, the pan you cook your dinner on and the lights that illuminate the food that sits on your kitchen table. This means that people will use it in their everyday life without a second thought. This unthinking use implies that before this pandemic, the demand for oil is ‘inelastic’.
Inelasticity of demand refers to the responsiveness of demand to price changes. For example, if a price decline of one percent leads to an increase in the volume sold of less than one percent, it means demand is not elastic. However, the pandemic has shifted the demand for oil to become elastic; a phenomenon never seen before in economics. This change to oil as demand elasticity has been enacted through the government’s closure of non-essential businesses. Oil producers unused to this new foreign environment have continued; if not increased, normal production levels, saturating a market with no demand for oil. As large industry is no longer in production, the firms receive no income, inhibiting their ability to purchase oil even at this historically low price. This leaves oil producers high and dry in a market unknown to themselves with virtually zero demand for their product.
This raises the question of why oil suppliers are not decreasing their supply levels to match the new lower levels of elastic demand. It turns out for oils suppliers that in the longer term it may be cheaper to find a place to store the oil than to closing production. This is influenced by the possibility of permanent damage to the oil wells that a temporary closure may spark. This damage would decrease their future economic yield. Even though in this recessionary environment, smaller producers may close, this is unlikely to put a dent in the overall aggregate market supply. Experts from Forbes magazine have implied that it would take two or three major suppliers working in tandem to restrict supply sufficiently to raise prices back to an equilibrium level.
The reluctance of the Russian and Saudi Arabian government to reduce supply has also tanked the current market price of crude oil. Following the OPEC meeting in early March, where the Russians failed to agree with Saudi Arabia’s plan to decrease production, there has been an ongoing price war between the Saudis and Russia. The relentless oversupply and price gouging before and during the coronavirus pandemic has shifted crude oil from a valued commodity to valueless in the chronically oversupplied world oil market. This price war has been directly linked to the lowest ebb in the crude oil market, the minus $37.63 a barrel on April 20th. This negative price reflects both a glitch in the futures contract market for oil and the derived hostile political environment that has been played out in the oil market. Both regimes in this time of crisis have continued their price war, resulting in paying other firms to take their oil off the market. As Russia and Saudi Arabia hold 10% of the global market supply, respectively, their impact on global trends are immense. The resident economic analyst at Blumberg magazine suggested that any cut in supply from both parties “would probably stop the skid in prices and improve their total revenue, alongside improving the revenue of countries and producers who did not cut back oil supply”.
The final major contributing factor to the oil price collapse is the futures contract market. The futures market deals with contracts for goods and services that are yet to be produced. Investors in this market secure lower prices on commodities by paying a lower price upfront in advance of any extraction or production occurring. Due to the unprecedented nature of this health and economic crisis, traders are running out of physical space to store all their oil. As a consequence of this issue, the futures contract price for oil has reached negative $37.63 a barrel on April 20th. This negative pricing means that investors are no longer paying oil suppliers to produce oil, rather spending an excess of $37.63 a barrel to convince other parties to store and purchase earth oil gained from futures contracts on the secondary market. Ryan Sutton, the commissioner at the Texas Railroad Commission, commented: “It’s the worst oil price in history, which shouldn’t surprise us, because it’s the inevitable result of the biggest supply and demand disparity in history”.
As the factors for oil’s steep decline are now apparent, the question turns to how this economic environment will impact consumers and governments. Economists are suggesting the economic recession from this global pandemic could be more prolonged and devastating than that seen in the great depression. The labour market is amongst the most devastated at current, with unemployment levels approaching historic highs and median income levels at their most vulnerable. This will have a flow-on effect into the product market, where consumers will not be as eager to spend their limited funds. This will cripple business bottom lines, creating a permanent economic limbo in which decreased consumer confidence will have a direct correlation to the catastrophic unemployment levels. Government deficits will also increase exponentially due to stimulus packages and bailouts designed to keep afloat a sinking economy. This negative economic outlook is horrifying from a business and consumer perspective and will remain a landmark point in modern business history for decades to come.