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The coronavirus outbreak has been grabbing all the headlines as of late, with work stoppages causing supply chain disruptions that are reverberating across the global economy. But what went down over the weekend in Vienna is a story of equal consequence. And it's going to impact the budgets of businesses, households, and entire nations.
Drowning in Oil
Here’s the problem. The world is drowning in oil. There’s just too much of it and it’s been like that for some time. The International Energy Agency said last December that the global surplus may reach 1 million barrels a day during the second quarter of 2020.
For much of last year, the Organization of Petroleum Exporting Countries (OPEC) and its allies, namely Russia, have been scaling back production in order to boost prices. After all, many oil exporting nations rely on the revenue from petroleum to support their budgets and government programs.
But the elephant (not) in the room is the United States, which isn’t an OPEC member. American oil producers have become so good at getting to that sweet sweet oil that in 2018 the U.S. surpassed Russia and Saudi Arabia to become the world's largest global crude producer.
The conundrum for OPEC and Russia is that if they cut back production, U.S. producers will simply swoop in and sell their product (mostly to China), and scoop up even greater market share. In fact, this is exactly what’s been happening.
In mid-2014, oil prices cratered from $115 a barrel to below $50 as OPEC turned on the taps full blast. The goal was to drive down prices in a bid to force American oil producers with high costs out of business. That didn’t work out super great. While some U.S. producers did close up shop, others were acquired by bigger entities, many found investments and lines of credit, and most just got way more efficient at pumping black gold.
After two years of financial pain due to low prices, OPEC and Russia coordinated and agreed to cut production in December 2016. And, just as they feared, it cost them market share. OPEC crude oil, which made up 35% of global supply in 2012, fell to 30% in 2019.
This Means (Price) War
That brings us to the latest turn of events. Last Friday, OPEC and Russia met at their secret lair in Vienna to discuss coordinating even more cuts. OPEC wanted to decrease production by one million barrels per day and asked Russia to cut 500,000 gallons. Russian president Vladimir Putin said, nah. Austerity measures and a stronger Russian economy means his country can cope just fine with lower prices.
Scorned, Saudi Arabia responded by saying it will now increase oil production. And in a bid to grab more of the Asian market, the Saudis are also cutting prices, throwing down the gauntlet and possibly starting a price war.
On Sunday when global oil markets opened, the price of oil sank a ghastly 24%, the worst day in almost 30 years. Fears are mounting that a barrel of oil, which fetched a scant $32.87 at Monday’s open, could fall as low as $20 a gallon, according to Goldman Sachs.
The risks of brinksmanship are considerable to both Saudi Arabia and Russia. The Kingdom needs Brent crude at around $80 a barrel to maintain a balanced budget, although the cash-flush nation can surely weather a deficit. Russia’s breakeven price is $45 a barrel. Sub-$30 prices are going to have a material impact on both nations. The question now is, which country will blink first?
The aerospace community is one of the big winners here, and it could not have come at a better time. Jet fuel is one of the biggest line item costs for airlines, and now they’ll be able to secure lower prices, mitigating the blow of the recent business downturn due to the COVID-19 outbreak.
Aerospace companies like SpaceX and Rocket Lab will also save money on fuel costs, and may pass on the savings to customers, bringing down launch prices. Trucking, logistics, and cruise lines will also benefit from lower fuel prices. The effects of the coronavirus is the big unknown right now, so being able to lock in lower prices is a godsend for these businesses contending with market upheaval.
The national average price of gas could fall below $2 by the end of the month, with drivers paying $1.59 in some states. While consumers will no doubt cheer the upcoming slide in gas prices, the automotive industry is likely a little rattled. Why? Because with the multi-billion dollar investments they’re making to transition to electrification, declining gas prices is the last thing on automakers’ wishlist.
Electric vehicles lose their appeal when gas is cheap. So it’s no surprise that shares in Tesla fell over 10% during yesterday’s wild stock market free fall that saw share prices of legacy automakers reach 52-week lows. In the near-term, traditional car manufacturers will likely be able to sell more of their very profitable crossovers and SUVs. But even they must be hoping that we haven't entered an era of permanently low oil prices since they need buyers for all the EVs they're developing.
A Downward Tumble
So what does this have to do with you? Cheap gas. Nice. Cheap flights. Great – once the virus scare subsides. Plus, if shipping costs decline, the costs of goods become cheaper. The consumer just keeps winning.
Not so fast.
Many high-cost shale U.S. oil producers are still heavily indebted, and this time, investors and banks may not come riding to their rescue. “There will be many bankruptcies in our industries and tens of thousands of layoffs over the next 12 months,” said Scott Sheffield, chief executive of Irving, Tex.-based Pioneer Natural Resources, one of the biggest independent oil companies.
A wave of bankruptcies and loan defaults in the oil space is especially problematic because, as economist Paul Krugman notes in his latest newsletter, "thanks to the rise of fracking, oil-price-related investment has become a major driver of the U.S. economy. It’s a significant share of total business investment, but more to the point, it’s highly volatile and actually accounts for most of the major swings in investment in recent years."
Oil still plays an outsized role in the economies of countries around the world, including the U.S. Low gas prices will provide financial relief to consumers, but if prices fail to normalize, the entire oil industry will tumble and pull the rest of the global economy down with it.