Crude Oil

Crude oil is a?naturally occurring petroleum product composed of hydrocarbon deposits and other organic materials. A type of fossil fuel, crude oil is refined to produce usable products including gasoline, diesel, and various other forms of petrochemicals. It is nonrenewable resource, which means that it can't be replaced naturally at the rate we consume it and is, therefore, a limited resource.

Crude oil is typically obtained through drilling, where it is usually found alongside other resources, such as natural gas (which is lighter and therefore sits above the crude oil) and saline water (which is denser and sinks below).

After its extraction, crude oil is refined and processed into a variety of forms, such as gasoline, kerosene, and asphalt, for sale to consumers.

Although it is often called "black gold," crude oil has a range of viscosity and can vary in color from black to yellow depending on its hydrocarbon composition. Distillation, the process by which oil is heated and separated into different components, is the first stage in refining.

Although fossil fuels like coal have been harvested for centuries, crude oil was first discovered and developed during the?Industrial Revolutinon, and its industrial uses were developed in the 19th century.?Newly invented machines revolutionized the way we do work, and they depended on these resources to run.

Today, the world's economy is largely dependent on fossil fuels such as crude oil, and the demand for these resources often sparks political unrest, as a small number of countries control the largest reservoirs. Like any industry,?supply and demand?heavily affect the prices and profitability of crude oil. The United States, Saudi Arabia, and Russia are the leading producers of oil in the world.

In the late 19th and early 20th centuries, the United States was one of the world's leading oil producers, and U.S. companies developed the technology to make oil into useful products like gasoline.1?During the middle and last decades of the 20th century, U.S. oil production fell dramatically, and the U.S. became an energy importer.

OPEC

The?Organization of the Petroleum Exporting Countries?(OPEC) was founded in Baghdad in 1960 and headquartered in Vienna. OPEC has 14 member countries including the Islamic Republic of Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela as its founder members. OPEC Members: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela, Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon, Angola, Equatorial Guinea and Congo. In its biannual meetings,?oil ministers agree on production quotas?for each member. They can control production since most of the member countries have state-run oil firms. OPEC’s?objective?is to co-ordinate and unify petroleum policies among member countries and ensure stable prices for petroleum producers. Most OPEC countries rely heavily on revenue from oil sales. High oil prices can hurt demand and low prices can affect the budget. Hence the organization tries to balance oil prices from getting too low or too high.

Petrodollar:

Petrodollars are?U.S dollars?paid to an oil-exporting country for the sale of the commodity. Put simply, the petrodollar system is an exchange of oil for U.S. dollars between countries that buy oil and those that produce it. The petrodollar was the result of the oil crisis in the mid-1970s?when prices spiked to record levels. It helped increase the stability of oil prices denominated in U.S. dollars.?The term regained notoriety?in the early part of the 2000s when oil prices rose once again.?Although petrodollars initially referred primarily to money that Middle Eastern countries and members of the OPEC?received, the definition has broadened to include other countries in recent years.

Petrodollars are the primary source of revenue for many OPEC members and other oil exporters.

Because they are denominated in U.S. dollars, the purchasing power of petrodollars relies on the value of the U.S. dollar. When the greenback falls, petrodollars do, too. The petrodollar system creates surpluses, which lead to large U.S. dollar reserves for oil exporters, which need to be recycled, meaning they can be channeled into domestic consumption and investment, used to lend to other countries, or be invested back in the United States.

History of the Petrodollar System:

The origins of the petrodollar system go back to the?Bretton Woods Agreement, which replaced the gold standard with the U.S. dollar as the reserve currency. Under the agreement, the U.S. dollar was pegged to gold, while other global currencies were pegged to the U.S. dollar. But because of massive?stagflation, President Nixon announced in 1971 that the greenback would no longer be exchanged for gold to boost economic growth for the U.S.

That led to the creation of the petrodollar system, where the U.S. and Saudi Arabia agreed to set oil prices in U.S. dollars. That meant any other country that purchased oil from the Saudi government would have to exchange its currency into U.S. dollars before completing the sale. That led the remaining OPEC countries to follow suit and price their oil in U.S. currency.

Petrodollar Recycling

The petrodollar system creates surpluses, known as petrodollar surpluses. Since petrodollars are basically U.S. dollars, these surpluses lead to larger U.S. dollar reserves for oil exporters.

These surpluses need to be recycled, which means they can be channeled into domestic consumption and investment, used to lend to other countries, or be invested back in the United States through the purchase of bonds and?T-bills. This process helps create?liquidity in financial markets in the U.S. By investing their surpluses, these exporters reduce their dependence on oil revenue.

Petrodollar recycling started with Saudi Arabia in 1979 as part of the U.S.-Saudi Arabian Joint Commission on Economic Cooperation.1The U.S. dollars that were used to purchase oil contracts were recycled back to the U.S. via contracts with U.S. companies. These companies would then partake in infrastructure projects in Saudi Arabia, which would increase U.S. imports into the country, lead to higher wages for certain employees, and help the overall economy.

The recycling system was also used to invest surplus dollars into sovereign wealth funds, the profits of which were used to invest in activities not related to oil, reducing the nation's dependence on oil.

Advantages and Disadvantages of the Petrodollar:

The petrodollar greatly helped to elevate the U.S. dollar's standing in the financial markets, as the price of the most important commodity in the world, oil, was linked to the dollar. This has partly aided the dollar in being the world's most dominant currency, which allows the dollar to continuously finance its account deficit by issuing dollar-denominated assets at very low rates. This has also allowed the U.S. to wield significant control economically over the globe.

On the downside, however, as the U.S. is the world's?reserve currency, it has to run account deficits to fulfill reserve requirements in a global economy that is continuously expanding. If these deficits were stopped then the lack of liquidity would lead to an economic downturn. As a catch, if these deficits continue then other countries will lose faith in the dollar, possibly leading it to lose its status as the world's reserve currency. This is known as the?Triffin Dilemma.

The Collapse of the Petrodollar System:

With the decline in the purchasing power of the greenback, some nations started to debate the benefits of the petrodollar system. Countries like Iran, Russia, and India have considered shifting the base value of their exports in their own currency rather than the U.S. dollar.

Venezuela dropped the petrodollar in 2017 and began pricing oil in euros and the yuan2

China is also moving away from using petrodollars and pricing the commodity in?Yuan, particularly putting pressure on Saudi Arabia to use petroyuan instead of petrodollars.

OPEC-Russia and the Shale Revolution:

Shale oil and gas is produced by?horizontal drilling and hydraulic fracturing (fracking)?of the porous rock holding oil and gas. The explosion in the production of shale gas?turned U.S to a net LNG exporter?by 2016.Compared to other oil-exporting countries, private companies are dominant in the U.S. oil industry and they have maintained a steadily increasing supply to ensure that prices pay for more exploration. From?2014 to 2016 the OPEC-Russia strategy was to reduce oil prices?to unprofitable levels to counter the loss of market share due to US shale oil and gas production. Though U.S. output dropped, the industry survived via cost-cutting, innovating, and becoming more efficient. When their government deficits increased, OPEC pursued?a new strategy of higher prices supported by production limits?was adopted. The OPEC–Russia production cuts during 2017-18 and high prices facilitated the rise in U.S. shale production which managed to offset part of the cut. The U.S became the largest crude-oil producer driven by the rise in shale oil production.

OPEC+

OPEC+ refers to the group of?24 crude producers?comprising 14 OPEC members and 10 non-OPEC members including Russia. The OPEC members’ bloc is led by Saudi Arabia while Russia is the biggest producer amongst the non-OPEC members. OPEC with 14 members controls 35% of global oil supplies and 82% of proven reserves. These figures increase to 55% and 90% respectively with the addition of 10 non-members to form the OPEC+ group. This enables the OPEC+ group to have substantial control of oil prices around the world economy.

Production quota:

The OPEC+ group was formed in 2017 to take coordinated actions to stabilize oil prices and have been undertaking corrections in supply in the oil markets since 2017.The last production cuts that the OPEC+ group committed to, for cutting oil production by 1.2 million barrels a day (BPD) or around 3% of members’ output, was scheduled to expire at the end of March 2020. The two top producers — Saudi Arabia and Russia — agreed to bear the brunt of the cuts. The OPEC group hoped to extend production quota beyond March 2020 and come to an agreement to reduce oil production by an additional 1.5 million barrels per day (BPD).

Russia refused to participate?in further production cuts because:

From Russia’s point of view, all this strategy of production cuts was helping U.S. oil producers at the expense of everyone else. It needs the money from its oil exports. Russia argued that it is dangerous to cut production during winter, as production sites could be damaged due to extreme temperatures in the Siberian oil fields which account for two-thirds of Russia’s production. Russia also wants a relook into the OPEC’s accounting rules for how gas contributes to the oil quotas. This could enable Russia to increase its oil production under the terms of the current agreement.

Corona virus outbreak and the aftermath:

A substantial decline in oil demand- World oil demand in 2019 stood at around 99.67 million barrels a day. After the global outbreak of the corona virus, the oil demand was set to contract in 2020 for the first time since 2009.According to the International Energy Agency, in the worst-case scenario i.e. if the corona virus continues to spread globally and China’s need for oil remains subdued, global oil demand could fall by as much as 730,000 barrels a day in 2020.Its?base case is for a slump in demand of around 90,000 barrels a day, assuming that the situation in China improves in the second quarter.

Saudi Arabia and Russia pledge to increase production:

When the deal for production cuts fell apart, Saudi Arabia and Russia pledged instead to ramp up production. Saudi Arabia announced that it would increase its production from 9.7 million barrels per day to 12.3 million, while Russia planned to increase oil production by 300,000 barrels per day.

Saudi Arabia also announced price discounts in March 2020.The oil market, in the face of a double crisis, collapsed.

The?futures contract for West Texas Intermediate?(WTI, the benchmark for U.S. crude prices), fell more than 300% to “negative” prices. Because of oversupply, it was becoming difficult to find space for the storage of oil. Each futures contract trades for a month. May contracts didn’t want to take delivery of the oil and incur storage costs and ended up paying to take the oil off their hands. This the lowest crude oil price ever recorded (the previous lowest was immediately after World War II).Brent crude, the benchmark for global oil prices, plummeted. Brent crude is less sensitive than WTI prices to supply-side shocks because it is priced in the middle of the North Sea where sufficient tanker storage is accessible, while WTI oil storage in the U.S. is limited as well as landlocked, making transportation relatively more difficult.

New deal:

Saudi Arabia and Russia, to stabilize the market, struck a deal with other major oil-producing nations of OPEC+ to slash production. The members agreed to cut production by 9.7 million barrels a day in May and June. This is the deepest cut ever agreed to by the world’s oil producers. After that, the group agreed to steadily increase production until the agreement expires in April 2022.

Conclusion

The oil price wars initiated by the OPEC+ group to counter the rise of the shale oil market in the U.S did not meet its intended objectives. The flooding of oil by Saudi Arabia and Russia in a global oil market already facing a deep fall in demand after the onset of corona virus nearly collapsed the oil market. The?latest deal is unlikely to solve the demand crisis?as the agreed reduction in output amounts to only about 10% of the world’s normal supply of oil. The estimates suggest that demand for oil has collapsed much further. The oil industry is also facing an?existential crisis in the form of electric vehicles?(EVs) which continue to gain market share. The emergence of clean energy is also a big problem for the oil industry. All these have made the future of the oil industry extremely unpredictable.

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