The Oil Price War

The oil price war has begun with Saudi Arabia reducing ‘Brent’ crude oil prices by more than 30 per cent. The reduction in prices to this extent is the first time ever since the 1991 Gulf crisis. This was due to a split between Saudi Arabia and Russia over the decision to reduce oil production.

Saudi Arabia led-oil cartel OPEC (Organization of Petroleum Exporting Countries) wanted to curtail oil production by 1.5 million barrels per day to counter the slowdown in demand due to the Corona virus outbreak. However, as Russia has not agreed to reduce its oil production, the oil company Brent of Saudi Arabia, has declared a price war by announcing the lowest price in this century.

The Coronavirus outbreak has started striking the financial markets and the real sector, especially investment in the energy sector. No country can produce oil as cheaply as Saudi Arabia. The “fiscal break-even” oil prices are not the same for all players. The fiscal break-even price gives an indication of the level at which oil producers’ break-even on their oil production and the exporters balance their trade budgets.

Russia’s fiscal break-even price is $42 a barrel, while Saudi Aramco’s is $83.60 per barrel. That’s why Riyadh’s Brent’s oil price reduction to $31 per barrel has triggered an effective and prolonged price war.

Will the plummeting oil price and the “race to the bottom” by Brent help the global economy from recession? The answer is not so straight forward especially on the “pass-through” effect of lowering oil prices on to the consumers and investors. Analysts opine that it will negatively impact the investment decisions in the energy sector and can be a drag on global growth. The consumers will gain only if the “pass-through” is perfect, without any tax burden.

Due to the Corona outbreak, there could be reduced oil drilling activity in the energy sector and there would be some cutbacks in demand. In turn, the prominent shale oil industry in US would be affected as it is also burdened with debt. However, as the industry is “hedged”, oil producers may not be significantly affected by the impact of plunging oil prices below the threshold. The oil-price hedges and investment-grade balance sheets can shield for low oil prices. However, the equity markets are sliding away from crude oil shareholders.

Analysts have revealed that for every $10 fall in oil prices, around 0.3 per cent would transfer to global GDP from oil-producing nations to the oil-consuming nations. The interest-rate strategists are also concerned as the Russian 10-year bond yields reached a record low of 2.56 per cent, and Saudi Arabian government bonds maturing in April 2030 is currently at 2.38%. The investment-grade energy debt in the US is also quite cheap, with option-adjusted spreads implying a rate of about 2.95% at present. The oil price war affects both commodity markets and capital markets.

India is world’s second largest consumer of oil. Riyadh’s race to bottom in oil price with Russia to tackle the world’s number one oil producer US Shale, can have a positive impact on India, as it would provide a “fiscal dividend”. A $20 dollar reduction in Brent oil prices can reduce India’s current account deficit by around $30 billion. The instability in oil prices is in the short run. India does not anticipate a prolonged fiscal dividend from this turmoil.

Russia and Saudi Arabia tried to keep the oil prices high for the last three years by decreasing their oil production. At the same time, US Shale company has increased its’ market share and is buoyant with profits. However, there was a geopolitical concern when US imposed sanctions on the Russian energy sector. With this price war, Russia has unilaterally decided to adopt a different strategy of increasing oil production and bring down prices. The overall impact of this could be grave for the OPEC cartel led by Saudi Arabia.

Script: Dr. Lekha S Chakraborty, Professor, NIPFP & Research Associate, The Levy Economics Institute Of Bard College, New York