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Macroeconomic impacts of the plunge in oil prices
Sharply lower oil prices are just one of the many consequences of the deep global recession resulting from COVID-19 and widespread, rolling government-imposed shutdowns of non-essential economic activities around the world. The global demand for oil has plummeted relative to productive capacity, driven by the sharp drop in global industrial production and dramatic curtailment of automobile usage and airline flights. Global industrial production is likely to match or exceed its 14% peak-to-trough decline of 2008-2009. Estimates put oil demand down roughly 20-30% relative to recent production of $100 million barrels per day (“OPEC+ cut: setting the stage for rebound post-Q2,” Henry Tarr, Berenberg, April 14, 2020).
*Obviously, oil producers and exporting nations including OPEC and Russia are severely harmed by the lower prices.
*In the U.S., the oil/shale producing sectors and regions are being hurt, while the shutdown precludes most consumers and businesses from benefitting. The lower oil prices will provide net benefits as the U.S. economy recovers.
*Under normal conditions, oil importing nations including most European nations, the United Kingdom, Japan, South Korea, India, and others would get an economic boost. However, things are not normal and in the near term those benefits will be constrained. As global economies begin to recover, the benefits to oil importing nations will become more apparent, but that will depend critically on future oil prices.
*Because the current conditions affecting oil markets and the global economy are unsustainable and bound to change, traditional rules of thumb used to estimate the economic impact of the recent big changes in oil prices should be used with caution and clearly qualified by underlying assumptions, particularly future prices of oil.
Normally, the demand for energy is relatively price inelastic in the short run, such that consumers of energy (households and businesses) benefit from the price decline, but their demand for energy does not increase much in response to the lower prices. Over time, as households and businesses adjust their behaviors, the benefits of the lower oil prices mount.
In the current situation, two critical factors constrain the upfront benefits that would normally accrue to oil importers: the economic shutdowns and the insufficient energy storage capacity. Oil importers still benefit, but not nearly as much as under normal conditions. Their benefits in the intermediate term depend on what happens to oil prices in the future when the current squeeze on storage capacity eases and bottlenecks in the global distribution of oil container ships dissipate.
In recent months, energy consumption has been naturally constrained by the full or partial shutdowns in most nations, contributing to the lower prices. Households cannot benefit from lower gasoline prices if they are not driving, and businesses cannot benefit amid production shutdowns. Airlines cannot benefit from lower jet fuel prices if they are not flying. As economies reopen gradually, oil and energy usage will rise gradually, from sharply lower levels. Business operating costs and household outlays for energy will be lower, but savings will not be nearly as much as under normal conditions. Presumably, the gradual rebound in oil demand will be associated with a rebound in oil prices.
The lack of storage facilities for a variety of petroleum products is a constraint that is limiting the ability of many energy consuming nations to import. Insufficient storage supply is most extreme in the U.S., but it is a problem globally, varying in intensity by energy product and by country. Along with the extreme supply-demand imbalance, the lack of storage capacity yesterday resulted in negative prices for May oil futures contracts that expire today. Simply put, with no place to store oil deliveries, oil traders (in physical and futures contracts) were forced to pay not to have oil delivered. Today the prices of the May futures are barely positive. The historically wide price gap between the expiring May oil contracts and the June contracts reflects the storage squeeze.
Beyond those technical details, in the near term, some energy importers will be limited in their ability to import cheaper oil. Reports suggest that many land storage facilities are full or close to full, and oil tankers on the seas are virtually full to capacity. Within months, those storage constraints and the current bottlenecks in shipping will unwind as consumption of petroleum products absorbs the excess supply. But that will likely be associated with a price adjustment.
The June contracts for WTI and Brent are $12.72/barrel and $19.21/barrel, respectively, and their futures curves predict that oil prices will rise, to $29.62 and $33.30 in December 2020 and $34.94 and $39.09 by December 2021 (Chart 1). It is striking that in real terms — that is, adjusted for inflation — the price of WTI is virtually the same as in 1973, before the first oil price shock stemming from the Arab oil embargo of the U.S., even though the U.S. economy is nearly 3.5 times bigger. If spot prices actually rise along the futures curve — and this path will be heavily influenced by the pickup in demand as global economies recover and production is cut — oil importing nations will face higher costs of refilling their storage facilities. The prices of petroleum products will likely remain below their year-end 2019 levels, conveying benefits to consumers and businesses, but by far less than is implied by current spot prices.
For the U.S., the lower oil prices are currently a net negative. The losses in the oil/shale industry will outweigh any benefits to other sectors to the economy that are just beginning their gradual, step-by-step reopening. Innovations and technological advances in the last ten years have lifted the U.S. to be one of the world’s largest oil producers and a net energy exporter. The Baker Hughes oil and gas rig count (an over-simplified measure of the drilling of oil and gas wells), which is reflected in the GDP accounts, is falling sharply (Chart 2). A severe supply glut and storage squeeze has forced widespread production shutdowns and a collapse in capital spending.
An estimated 310k people work in oil/shale exploration, and multiples of that amount work in various industries that service the oil sector, including engineering and professional services, finance, and an array of service sectors. Many jobs will be lost. The collapse in capital spending will accentuate the decline in total business investment (Chart 3). Many oil drilling and service firms, particularly those who had been operating on leverage, will be closed, their assets absorbed by better situated firms (at deep discounts). Some banks may incur losses that impinge on their capital and impair their lending or even force them out of business. Other creditors have incurred sizable losses and are severely impacted. Over time, the shakeout will force surviving oil/shale drillers to be more efficient, and technological advances will further lower marginal costs of production and distribution. But, in the near term, some shutdowns are disruptive and very costly.
The lower energy prices are expected to benefit U.S. consumers and non-energy businesses as the economy recovers (Charts 4 and 5). The lower costs of energy will provide more purchasing power for consumption of non-energy goods and services. Business operating costs will be lower than pre-crisis levels. As the peak driving summer season approaches, U.S. consumers are expected to take advantage of lower gasoline prices, especially as they are slow to resume airline and international leisure travel.
If oil prices remain low and help net energy importing nations, they will exert concentrated negative economic and financial impacts on OPEC, Russia, and many emerging market nations that rely on energy products and have large debt burdens. This will dampen the global economic recovery and the rebound in trade volumes, and will pose serious challenges to global policymakers including the IMF and World Bank (“Critical economic issues related to COVID-19”, April 6, 2020).
Chart 1: Brent and WTI crude oil futures curves
Sources: New York Mercantile Exchange, ICE Futures Europe Commodities, Bloomberg and
Berenberg Capital Markets
Chart 2: U.S. oil and gas rig count
Sources: Baker Hughes and Berenberg Capital Markets
Chart 3:
Chart 4: Retail regular gasoline price
Sources: American Automobile Association, Bloomberg and Berenberg Capital Markets
Chart 5: Jet fuel spot price
Sources: Bloomberg and Berenberg Capital Markets
Mickey Levy, mickey.levy@berenberg-us.com
Roiana Reid, roiana.reid@berenberg-us.com
Member FINRA & SIPC
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