It is being fought on two fronts: central banks and governments against COVID-19 and Saudi Arabia against Russia. After the Fed and the Bank of England introduced emergency rate cuts it was the turn of the ECB. The European Central Bank will provide banks with loan and would increase its bond purchases by €120 billion this year. The most anticipated move, namely cutting rates, has never materialized as Christine Lagarde said that narrowing the gap between members’ borrowing costs was not the ECB’s job. The market did not take it kindly. The ECB move came after Donald Trump banned European flights to the US and as the coronavirus shows no sign of abating. The net result was an 11% slump in the FTSE-100 index. The S&P 500 fell 9.5% and has lost almost 30% of its value in less than a month.
On the oil front the picture is not rosier. After the weekend’s fall out neither Russia nor Saudi Arabia are willing to blink. The planned technical meeting of the OPEC+ group planned for March 18 will not go ahead. Empty phrases aside (the door is still open etc.) there are practical steps being taken to ramp up production and flood the world with oil. A sure sign of it is the rise in shipping costs. Rates have risen by well over 100% and it now costs between $80,000 and $110,000, depending on destination, to hire a VLCC for a day. All this is partly because Aramco has reportedly made a rare appearance in the spot shipping market confirming that the spigots will be open soon. The CEO of Gazprom Neft also rushed to reassure the market that his company will raise production by 40-50,000 bpd in April. Front-month Brent lost nearly $3/bbl and closed below Monday’s settlement. It is now nearly $2/bbl below the second month and the M1/M12 price differential was –$9.54/bbl at last night’s settlement. Extra salt was rubbed into the wounds of oil bulls -if there is any left- as the RBOB contract was pushed over the precipice and lost almost $9/bbl equivalent on the day and settled right on the February 2016 low.
Oil is on uncharted waters
The present downturn in oil prices is unlike any other in the past. When prices fell before it was usually for one and not the combination of two reasons: either demand eroded, or supply grew. The latest examples are from 2008 and 2014. Twelve years ago, irresponsible risk-taking by financial institutions coupled with lack of regulatory action pushed the world into recession. Demand tanked and oil dived from $147 to $36/bbl in the space of six months. The price tsunami was followed by supply side response. OPEC cut its production from nearly 32 mbpd in 2008 to below 29 mbpd in 2009. Prices recovered. The next bear market came when Saudi Arabia decided to fight for market share in 2014. The group’s production rose from 29.8 mbpd in 2Q 2014 to 31.9 mbpd a year later. The difference between 2014 and the present day is that back then global oil demand was showing an annual growth of 630,000 bpd, the world’s economy was expanding by almost 3% and Brent started the second half of 2014 well above $110/bbl.
This time around the market is facing a double whammy. There is a clear and present danger that the global economy will contract this year or at least in the first six months of 2020. This will lead to negative demand growth. The IEA has already foreseen a 100,000 bpd demand destruction for 2020. For the first quarter of the year this contraction will be 2.4 mbpd and for the first half 1.2 mbpd. The economic consequences of the coronavirus have deteriorated since the agency released its latest estimates therefore, it is entirely feasible that further downward revisions will take place next month and after. The second half of the year that is presently expected to see a demand growth of 1 mbpd compared to the same period of 2019 could also experience decreasing thirst for oil.
When demand erodes, oil producers react. This is what the Saudis proposed last week, and this is what Russia rejected. We will never know if it was a bluff from Russia thinking that the Saudis would go ahead with the reduction anyway. If it was, the bluff was called. The result is a $20/bbl dump in oil prices with volatility spiking above 100%. Brent and WTI has come dangerously close to the 2016 lows and the front-month RBOB contract has matched it.
A demand shock has been swiftly followed by a supply shock. The control of the former is out of the hand of policy makers or market players. Central bank intervention is not working, and stock markets are falling. Some relief can only come from the supply side but key participants (Russia and Saudi Arabia) are reluctant to give concessions. The consequences are currently devastating, but they can also be far-reaching.
It is fair to say that the events of last weekend took most by surprise – Russia deciding not to join the proposed production cuts and then the kingdom upping the ante, slashing its selling prices and promising to ramp up production. On Wednesday the UAE joined its regional ally in increasing its output. It is one thing that the OPEC+ alliance has fallen apart and in about two weeks everybody is entitled to produce as much as it can. Perhaps the more important question is whether the existence of OPEC, as the guardian and the central bank of the oil market, will be justified in the future. After all, its biggest producer took the unilateral step in times of economic hardship that will have a negative and, in some cases, disastrous effect on fellow members. Of course, reconciliation is always possible but equally the organization might never recover from the current crisis. If OPEC, as a producer group ceases to exist after 60 years the lower-for-longer mantra will become lower-for-much-longer.
The coronavirus will be beaten at some point – albeit this point seems further away by the day. Stock markets and oil demand will rebound. However, if there is no willingness from producers to manage the global oil balance the expected V-shape recovery will turn into U-shape or even L-shape.